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© Copyright 2000 Rogers Media. The following article first appeared in the June 2001 edition of
BENEFITS CANADA magazine.
Targeting the new MSCI
Morgan Stanley Capital International has revamped the way it builds its indexes. Here's what the
changes mean for institutional investors.
By Timothy Thompson
Last month, Morgan Stanley Capital International (MSCI) announced changes to its index construction
methodology. These changes will apply to all indexes constructed by MSCI, including the MSCI World index
and the MSCI Europe, Australasia and Far East (EAFE) index. The new methodology has two major components.
First, MSCI will adjust the number of shares used in its various index calculations. Second, it will
broaden the market coverage of each country in its indexes.
In general, MSCI has based the weights of the stocks in its various indexes on the full value of each
company's outstanding shares. The new methodology will base the weights on the value of the shares that are
actually available for investors to trade. The shares available for investment by the general public are
called the free float. Shares held by governments, corporations and insiders are not part of the free
float, and they will be excluded when calculating company weights. This free float adjustment will make the
MSCI indexes more representative of the available investment opportunities around the world.
MSCI currently includes about 60% of each country's total market capitalization in its indexes. Under the
new methodology, 85% of each country's market capitalization will be targeted for inclusion. Again, this
will make the MSCI indexes more representative of the investment universe.
BEST PRACTICES
A consensus has developed among industry participants that free float adjusted indexes better reflect the
investable opportunity set. MSCI's current index construction methodology overweights those companies with
a low free float. Similarly, stocks with a high free float are penalized with a relative underweight in the
current MSCI indexes.
In the past, it has been argued that using total outstanding shares in index calculations is a more
objective methodology because the value of outstanding shares is consistently defined and widely available.
However, industry best practices have now determined that the free float adjusted weight of a stock is a
better reflection of market weight. MSCI will also be in line with other major index providers by moving to
a free float adjustment methodology (see "Comparing benchmarks," above).
As with the move to a free float methodology, the switch to increased market coverage reflects industry
best practice. There has been an increase in corporate activity, particularly mergers and acquisitions,
over the past several years. This has led to fewer names in the indexes and an increase in concentration in
the weight of individual securities. The upcoming index changes should subdue this concentration trend. For
example, MSCI's EAFE index contained 1,300 names in 1995. Currently, this index has approximately 900
names. However, this list may grow to 1,600 names when the changes are complete.
The potential impact from these index changes has attracted the attention of investors worldwide. Although
some believe that passive managers will be impacted the most, active managers, investment dealers and other
investors are also interested in the changes.
MSCI estimates there is US$3 trillion benchmarked to its various indexes worldwide, with only 10% managed
passively. Passive managers will need to adjust their portfolios to reflect the MSCI index changes. But how
and when these changes will take place is expected to vary considerably among managers.
It is also not certain what active managers and other market players will do to adjust their own portfolios
or to try to win against passive managers. This activity may impact the market in some way.
All investors who are sensitive to benchmarks will buy high free float companies and sell low free float
companies to reflect the index changes. For example, some European governments still have sizeable
shareholdings in their countries' telecom companies. Under the new regime, the weight of these telecom
companies will fall as the indexes are adjusted to exclude government holdings.
MSCI released the exact changes to individual stock weights in mid-May. While specific changes were not
available at press time, some notable adjustments in country weights are expected in the MSCI EAFE index.
The weight of the U.K. and Switzerland will probably increase as these countries have a relatively large
number of high free float companies (see "Weight watching," above). On the other hand, the weights of
Japan, France and Germany are likely to decline. These countries have many low free float companies due to
extensive government and corporate cross-ownership holdings. The weight of the U.S. is set to increase by
almost 8%. This reflects the fact that free float is highest there.
The move from 60% to 85% target market coverage should also result in more market activity.
Benchmark-sensitive investors will be buying the new stocks added to the index and selling some of their
existing stocks to fund these purchases.
There are likely to be some additional costs associated with the implementation of the portfolio changes.
Turnover in an EAFE portfolio is estimated to be between 30% and 35%. That is, 30% to 35% of the portfolio
will be sold and replaced with other positions. With turnover comes costs that could include brokerage
commissions, market impact costs, custody and other administration charges.
There will also be an impact in currency markets. Most investors will sell Japanese yen to buy British
sterling, reflecting the adjustments in country weights. Canadian investors who follow a MSCI World
allocation will be buying American dollars to pay for the increased weight in U.S. securities.
Managers, plan sponsors and consultants are advised to devote additional resources to monitoring their
portfolios. Overall, all parties should try to minimize costs wherever possible.
Index turnover will have an impact on the cost base of portfolios. This is particularly an issue for those
who are close to the 30% foreign content book value limit.
ASSET ALLOCATION
Canadian pension plans may want to re-examine their allocation to U.S. and EAFE assets. Those plans with
foreign holdings benchmarked to the MSCI World ex-Canada index need to be aware that the weight of the U.S.
is likely to increase from approximately 50% to close to 60%. Those plans that have a 50%/50% U.S. to EAFE
benchmark may need to revisit the weights they have assigned to these asset classes.
Managers of synthetic, derivative-based strategies may see new opportunities for improving their investment
process. In some cases, alternative futures contracts may be used to narrow the tracking to the MSCI
benchmark constructed using the new methodology. Fortunately, this adjustment may have only small
implementation costs.
Over the transition period, there will be two types of benchmarks available for performance measurement
purposes: the standard MSCI indexes and the provisional indexes. Some managers may have switched to the
provisional indexes once the changes were announced last month. Others will follow the MSCI two-phased
implementation plan and make adjustments in November and May. Still others may phase in their
implementation over the 11-month transition period using a combination of the provisional and standard
indexes as a benchmark.
Regardless of timing, however, clarity of measurement, performance attribution and communication will be
critical during this period. Overall, international investors will benefit from improved benchmarks that
reflect broader market coverage and the investable opportunity set.
Timothy Thompson is managing director with TD Asset Management Inc. in Toronto.
Tracking change
Changes to the MSCI indexes will be implemented in two stages.
The Morgan Stanley Capital International (MSCI) index changes will occur in stages. In mid-May, MSCI
released details to the industry about the new indexes. The changes were not available at press time, but
MSCI is expected to begin publishing a provisional index for various MSCI indexes.
The standard MSCI index changes will occur in two phases, with the first phase ending on Nov. 30, and the
second on May 31, 2002. The standard MSCI index information will be published with the provisional index
data, which will include the full impact of all changes.
During the first phase, MSCI will implement about half of the free float adjustment changes. At the same
time, it will add half of the ultimate weights of each of the new companies that result from the increase
to 85% market coverage. MSCI will delete any companies removed from its indexes at this time.
In the second phase of the standard index changes, the remaining free float adjustments will be made and
the weights of all the new companies will be increased to their full index weight. As a result, the
standard index will look exactly like the provisional index at the close of trading on May 31, 2002. The
calculation of the provisional index will expire on this date.
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