Free-float adjustments
We are compelled to respond to Robin Norton's Feb. 19 letter to the editor as we feel the author has misrepresented the index methodology changes and unfortunately condemned the benefits of indexing in international equities as a result.
As background, there has indeed been a flourish from index calculators (including STOXX, FTSE and MSCI) over the past year or so to adopt a methodology based on free-float weighting of the index constituents. This is partly because of investor demand for more investible and market representative indexes, but also because of information on free-float becoming more available and more consistent across markets.
While these changes are and will be beneficial in improving the investibility and coverage of the indexes, there is, of course, no free lunch. Additional turnover and therefore portfolio cost is created. However, these must be placed in their proper context.
Take the example of MSCI's EAFE index, the most commonly used benchmark by U.S. plan sponsors investing internationally. While the final, float-adjusted weightings and new constituent names are not yet announced, best estimates expect the turnover due to the methodology changes (which includes the concurrent increase in market coverage from 60% to 85%) to be about 25% to 30% in total, spread over this year and next. Given that recent annual turnover in the EAFE index has been over 10% (1999 and 2000) then this does not represent a significant annual increase.
And, just to be clear, U.S. indexes can and do incur significant turnover. In 2000, for example, the Standard & Poor's 500 index percentage turnover was almost 9% in 58 names on an adjusted market cap basis.
As for active management opportunities based around the index changes, we suggest this is not the easy trade the author suggests. The time extensive implementation planned by MSCI has introduced sufficient uncertainty as to how much will be traded, and more importantly, when it will occur. The uncertainty and risks involved has already diffused the majority of the interest in "gaming" the changes. In fact, using one major index provider's own numbers, the performance spread of the expected added names vs. the deleted ones, for an EAFE portfolio, actually shows a spread of -6.3% (from Dec. 11, the date of MSCI's announcement, to Feb 27).
Indexing in international markets has provided and will continue to provide significant benefits to investors through the three dimensions of risk, return and cost.
The benchmarking decision is key for international equity investing and the improvement to their index series by the major providers can only benefit investors. The plan sponsors will be the primary beneficiaries as they will have better benchmarks to measure their active managers, better benchmarks for their core or quant-active holdings and more appropriate and complete benchmarks for creating policy decisions.
Rob Ginis
head of strategy
international equity management group
Barclays Global Investors NA
San Francisco
