NEW YORK - The rebalancing of the Morgan Stanley Capital International Inc. indexes will have "unprecedented implications" for the benchmarks, according to a new report from Merrill Lynch & Co., New York.
The report estimates total transition turnover in the MSCI Europe Australasia Far East index will be 32%, and in the MSCI World index, 34%. It did not estimate the costs.
A recent report from Barclays Global Investors, San Francisco, said the total turnover involved in switching from the old EAFE to the "enhanced" EAFE would be 28.6% and the cost would be 29 basis points for a $1 billion portfolio.
"Looking at turnover is a very good way to measure what costs will be," said Steven Schoenfeld, managing director and head of international equity management at BGI. The turnover numbers in the BGI report were estimated in November, and when BGI measured turnover again in early February, it estimated there would be 31% turnover.
According to Merrill's report, all of the major countries in the indexes will have double-digit portfolio turnover rates for this year and next. Turnover rates will vary significantly by country, however, ranging from a high in 2001 of 37% for Belgium to just 7% for Finland.
Merrill provides BARRA Inc.'s estimated tracking error of the current index relative to the projected MSCI indexes after the transition. For the EAFE, the tracking error is 1.03%, and for the World index, 1.13%.
However, the report points out that recently BARRA has tended "to underestimate actual tracking error by as much as 100%."
Silvio Lotufo, an analyst and co-author of the report, said, "A 1% tracking error is not necessarily trivial, but it could be even higher because BARRA has underestimated tracking error in the past." He added that "if you're a passive manager, you try to keep tracking error within 1% and might have to make significant adjustments (during the transition) to keep it down."
The report points out that countries that are now underrepresented in the indexes, and whose companies have high free float, face the potential complication of investment flows into smaller companies as MSCI attempts to increase coverage to 85%. Because smaller companies have lower liquidity, "the market impact can be material," according to the report. (MSCI has said it will increase the market coverage of its indexes from 60% of the full market capitalization of every sector within each individual market to 85% coverage, based on a free-float basis.)
Mr. Lotufo said "midcap companies of $2 billion to $5 billion in size will come into the indexes, and at the stock (market) level this will have effects." He added the Merrill report is only calculating the effects that come from passive investors' buying these stocks, and that "if active investors get involved, it will have an even greater impact" on the stock prices of these companies.
The report estimates 437 stocks will have to be added to the MSCI World index as a result of the policy changes, representing an increase of more than 30% in the number of names now in the index.
200 U.S. additions
On a country basis, Merrill's report said the United States will require more than 200 additions because of the U.S. companies' relatively high free float and low current representation, relative to the new 85% target. The United Kingdom is second, with 49 additions, and Japan is third, with 47 projected additions.
Although Japan is represented now at 71% in the EAFE and World indexes, it is projected to have the largest weight decline, at 2.71 percentage points of any country in the indexes. That's because some stocks (such as NTT Corp.) will experience significant weight declines as a result of the free float adjustment. In fact, the report estimates that to adjust its free float in the index, index funds will have to sell 266,000 shares of NTT, which translates into about 17 days of "normal" daily volume.
After Japan, the countries with the largest weight decline in the EAFE and World indexes are France, with a drop of 1.22 percentage points, and Germany, 1.06 points. These decreases should result in net outflows of $8.5 billion for Japan, $4 billion for France and $3.4 billion for Germany.
The largest weight gainers in EAFE are the United Kingdom, with an increase of 4.26 percentage points, and Spain, 0.53. These increases will lead to net inflows of $8.3 billion for the United Kingdom and nearly $1 billion for Spain.
In the World index, the United States is the largest weight gainer, with 5.97%. This should lead to a net inflow in the United States of just less than $9 billion.
The two largest sector weight gainers (information technology and energy) and the two biggest sector decliners (consumer discretionary and telecommunications services) in both the EAFE and World indexes are identical, according to the report. Information technology gains 0.41% and 0.8% in the EAFE and World indexes, respectively. Energy gains 1.17% and 0.66% in the EAFE and World indexes, respectively, while telecommunications services lose 0.67% and 0.23%, respectively, and consumer discretionary loses 0.68% and 1.45%, respectively, in the EAFE and World indexes.
The projected weight gains in energy and information technology should lead to net inflows of $3 billion and $2 billion, respectively, while the weight declines in consumer discretionary and telecommunications services sectors should lead to net outflows of $3.4 billion and $1.5 billion, respectively.
A sampling of the companies whose weights in the indexes will decline shows substantial selling of shares will be necessary. In addition to NTT, others include France Telecom SA, which will require total indexer selling of about 16 million shares, roughly five days of "normal" volume; Deutsche Telecom AG, which will require indexer selling of about 45 million shares, about five days of "normal" volume; Japan's Toyota Motor Corp., which will require total indexer selling of about 28 million shares, roughly 10 days of "normal" daily volume; and Bank of Tokyo-Mitsubishi, which will require total indexer selling of about 76 million shares, approximately 16 days of "normal" daily volume.