In the past year, much has been written about the impending changes to the MSCI indexes, including the EAFE index, and the implications for plan sponsors and fund managers. But as we approach Nov. 30, the date of the first step of the two-phase implementation of the change, the industry continues to focus on the narrow issues of transaction costs, possible gaming the changes, and the potential performance differences between the current, or old, EAFE and the new float-adjusted provisional EAFE. While these issues warrant careful scrutiny, they mask the much broader impact of the benchmark changes - EAFE and other key international equity benchmarks will be much harder for traditional active managers to beat.
The truly significant implications of Morgan Stanley Capital International's methodology evolution is that the primary benchmarks for international investing - the Europe Australasia Far East index and the All-Country World index ex-U.S. - will become deeper, broader and more reflective of the investible non-U.S. equity opportunity set.
The conventional wisdom within the investment industry is likely to become outdated and irrelevant. This line of thinking holds that because of greater inefficiencies in international markets, to quote one prominent consultant, "beating EAFE is like shooting fish in a barrel." Thus, based on relative performance of the recent past, "the only way to go" for non-U.S. equities is to use traditional active fund managers. Starting Nov. 30, the time is up for this kind of thinking, as the remaining sources of "easy" outperformance will be eliminated.
There are several reasons why the majority of active managers have seemingly easily beaten the EAFE benchmark in the past decade. First, there were numerous opportunities outside of the index, either through positions in non-index stocks or through well-timed dabbling in non-index countries. The newly broadened index coverage, to 85% of investible market capitalization, means fewer key stocks will be missing from the benchmark. For example, in 1999, a stellar year for active managers, a mere 1% exposure to NTT DoCoMo KK - an obvious telecom blue-chip that was not in EAFE - would have added 3.4 percentage points in outperformance. NTT DoCoMo and other key stocks that were conspicuously missing from EAFE in the past will be included in the index starting this month.
In the past, it was also common for an international manager to have an EAFE benchmark but be able to invest in emerging markets and Canada (and sometimes even the United States.). Today the investment industry is applying benchmarks with more precision. It is probable the plan sponsor or consultant now will specify a more appropriate benchmark, depending on the firm's intended investment universe - thus for the total non-U.S. universe, the appropriate benchmark would be MSCI ACWI ex-US or FTSE All World ex-U.S.
Another major source of median manager outperformance of EAFE in the 1990s was the consistent underweighting of Japan. Just as this underweighting hurt performance in the 1980s, it helped in the '90s. The median active manager underperformed EAFE by 3.2 percentage points from 1982 through 1989, and outperformed EAFE by 2.2 percentage points from 1990 through 1998. In the '90s, Japan's weight in EAFE fell from an extreme of 61% to 22%. Going forward, with Japan's weight now at 21%, active managers are not likely to underweight or overweight Japan by the same magnitude; and even if they do, a one-third over- or underweighting will have a much smaller impact on overall performance. MSCI's application of float-adjustment also will minimize instances of extreme distortions of either country or stock weights.
Finally, the forces of globalization and competition dramatically have narrowed the "efficiency gap" between American and developed international equity markets. Transaction costs have fallen by 21% in the EAFE markets since 1998, and earnings and economic information is absorbed much more rapidly than in the past.
The belief that indexing and related quantitative approaches are logical for U.S. equity investment yet inappropriate for "less-efficient" international markets is clearly outdated. Will plan sponsors and their consultants wait for several years of traditional active manger underperformance before shifting their core international equity holdings to structured, risk-controlled strategies?
The environment for international investing has changed dramatically since the late 1990s, and this already has become apparent in the underperformance of the median active manager relative to the EAFE benchmark for the 12 months ended Sept. 30. The implementation of MSCI's methodology changes - starting Nov. 30 and finishing with the second phase May 31 - will accelerate the trend, as more appropriate benchmarks will better reflect the investment opportunity set. In the coming years, conventional wisdom will be transformed, and it will recognize that the case for risk-controlled strategies such as indexing and structured active investing is as strong for international stocks as it is for U.S. equities.
Steven A. Schoenfeld is managing director and head of international equities at Barclays Global Investors in San Francisco.