In the next few weeks, two major equity indexes will undergo substantial changes. On May 31, the Morgan Stanley Capital International indexes, including the EAFE index, will undergo the second of their two-phased reconstruction. On June 28, the Russell indexes will undergo their annual reconstitution. Both events will affect a range of investors in a number of unpredictable ways. How and when different types of investors react to these changes is the subject of considerable debate. One thing is clear: Markets don't always act as expected.
As we approach these rebalancings, market participants will again spend considerable time and resources determining whether there is value to be generated by "gaming" index changes - that is, betting on the predictability of index change impact. The mix of market participants - fund sponsors and active and passive investment managers, as well as consultants and brokers - can create volatile results. Accordingly, plan sponsors should remain wary of the risks associated with gaming index changes. It is important to understand that the information used to generate investment strategies to game index changes is based on average, ex post results, but that those averages may poorly predict a single event given high levels of uncertainty.
Conventional wisdom has assumed that index managers' blind pursuit of a benchmark provided opportunities ripe for generating "riskless" return through gaming strategies. In fact, strategies based on gaming index changes can be quite risky. Investors who pursue gaming strategies bear concentrated, non-diversifiable event risk subject to several highly uncertain variables. These variables include participation by non-indexers or "speculators" (such as hedge fund managers, fundamental managers and the proprietary trading desks of brokerage firms) and changes to underlying fundamental factors such as sector, style and capitalization exposures, as well as company-specific risks. Failing to adequately gauge these uncertainties increases the potential for disappointment.
The lesson of market unpredictability was borne out in Phase I of MSCI's transition to free-float weighted indexes with extended market capitalization coverage, which became effective after the global markets closed Nov. 30. The completion of Phase I concluded many months of predictions, most of which were wrong. It might seem obvious that markets can act contrary even to a majority of expectations. Nonetheless, investors need to consider this point seriously when assessing the risks undertaken by their investment managers.
MSCI provided a long lead time and offered the new index in an attempt to mitigate index-driven price distortions. To MSCI's credit, its methodology avoided large price distortions during the implementation of Phase I. Price distortions can accompany index changes as passive managers rebalance their portfolios to match the benchmark. This is particularly true if index changes are concentrated in a relatively small number of securities, or in the case of a benchmark where indexed assets represent a relatively large proportion of its total market capitalization. The value of assets indexed to EAFE represents approximately 5% of that index's market capitalization. To avoid risk relative to their benchmarks, passive managers often rebalance their portfolios on the effective date of the index changes. These concentrated index-trading flows can cause significant price pressure around the effective date of the index changes. The distortions are typically concentrated in the "inflows," index additions plus weight increases, and the "outflows," index deletions plus weight decreases. The MSCI rebalance, with index turnover forecast around 30% (buys plus sells equal to about $100 billion), was widely expected to cause such distortions.
Strategies to avoid the impact of these anticipated distortions were marketed aggressively by the investment community. A common recommendation was to rebalance early, before the MSCI transition dates of Nov. 30 and May 31. But following the first few months after MSCI's May 2001 publication of the provisional index, significantly less rebalancing had occurred than anticipated, raising the expectation for massive market impact on Nov. 30. Indeed, as the last few days of November approached, there was widespread speculation of significant outperformance of the inflows relative to the outflows.
Surprisingly, activity during the last two days of November revealed the opposite effect, with inflows underperforming outflows, in some cases dramatically. This reversal from expectations has since been attributed to considerable activity by speculators, who were positioned to provide liquidity to indexers in hopes of profiting from the expected asset flows. The reversal illustrates the risky nature of gaming index changes.
Gaming of index changes typically is undertaken by two categories of speculative investors. The first is quantitative and traditional investment managers who rely on gaming as only one part of an overall strategy. Quantitative managers use gaming strategies to generate outperformance, often in the context of a risk-controlled "enhanced index " strategy. Traditional active, or fundamental, managers may rely on liquidity pools surrounding index changes to readjust their portfolio exposures. The second group of investors implements gaming strategies in a more concentrated fashion. These investors, including hedge fund managers, may allocate substantial assets to gaming strategies. The precise mix of speculative investment activity surrounding index events often has a major impact on the relative performance of the affected securities.
Although the MSCI situation is particularly dramatic, the graveyard of unexpected index change performance is littered with similar outcomes. Several studies have shown that the "addition effect" of stocks being added to the S&P 500 has contracted considerably over the last year. In fact, the "capturable" S&P 500 addition effect (i.e., the market-adjusted return from the market close one day after S&P announces the addition through the close of the effective date of the addition) became negative for the first time in a decade.
Recent Russell 2000 reconstitutions also have resulted in uneven and volatile performance of gaming strategies. As with the MSCI transition, investors expect the Russell 2000 inflows to outperform outflows, particularly on the reconstitution's effective date. Although this was the case in 1999, the reconstitution in 2000 worked in reverse, particularly over the last couple of hours of the June 30 effective date. But the 2001 reconstitution performed as expected.
There is, in short, no way to predict the market reaction to the changes this year.
Jonathan E. Cohen is a quantitative management specialist at Northern Trust Global Investments, Chicago. The opinions expressed in this commentary are those of the author and do not necessarily reflect those of the Northern Trust Corp. or its subsidiaries.