John Spence

Q&A with Khalid Ghayur, MSCI Index Development

Khalid Ghayur knows a thing or two about indexes. He is global director of research and chief investment strategist for index provider Morgan Stanley Capital International (MSCI). Mr. Ghayur, who answered our questions from his Princeton office, is responsible for coordinating all of MSCI's global benchmark research and new product development efforts.

Q: Up until now, MSCI used only one variable, price-to-book ratio, to determine value or growth for its international style indices. Under the new methodology to be implemented in 2003, eight factors will be used to determine style. Why did the old system become outdated?

A: In 1997, MSCI was the first index provider to serve the investment needs of international style investors with its Global Value and Growth index series. At that time the indices were based on a style index construction methodology that segregates value and growth securities on the basis of their price-to-book value ratio.

While this methodology was appropriate at the time, it has become apparent that investors are using more complex variables for style-based investing. To ensure that our indices reflect the state of the art in style investing, we conducted an extensive consultation with our clients on how the indices could be enhanced, which we finished two months ago. So MSCI's enhanced methodology is really a direct reflection of investors' evolving views on style definition and segmentation.

We recognize that to some extent, the determination of style is evolutionary and needs to be revisited from time to time.    -Khalid Ghayur, MSCI

Q: Under the new methodology, parts of a company's market capitalization can be in both the growth and value indexes. Why is this preferable to simply pigeonholing a company in the growth or value index?

A: Allocating the full weight of a security in either the value or growth index may be acceptable if one of the two styles clearly dominates. For many securities, one style, either value or growth, is clearly dominant and we attribute that security's entire free float-adjusted market capitalization to either the value or growth index.

For those securities where a style is not clearly dominant, forcing a security in one or the other index will increase the specific risk of the index, and may be arbitrary. In addition, it is not consistent with what actually happens in the market, as some growth managers and value managers may hold some of the same stocks in their portfolios. For these reasons, MSCI will partially allocate the weight of a security - one that is not clearly value or growth - to for example the growth index, with the reminder to the value index.

Q: Can you explain the buffer system and how it reduces turnover between style indexes?

A: The value and growth indices will be rebalanced every six months, at the end of May and November. At those times, buffer zones will be used to manage the migration of securities from one style sub-index to another. The purpose of the buffer zones is to prevent securities with the weakest value and growth characteristics from changing unnecessarily their style classification at the time of the semi-annual style index review.

Based on simulations for the UK, Japan and the U.S. over the last 5 years, the reduction in index turnover ranges from 30 to 50 percent, compared to the index turnover resulting from the current value and growth methodology.

Q: How is determining style an evolutionary process?

A: MSCI conducted an extensive consultation and gathered feedback on our value and growth methodology with asset managers, asset owners, and consultants worldwide. We recognize that to some extent, the determination of style is evolutionary and needs to be revisited from time to time.

Q: Will there be index turnover when the new methodology is implemented in 2003?

A: Yes, however, one of the key features of MSCI's enhanced value and growth methodology is the use of buffers, which as I explained significantly reduce index turnover. This implies that going forward, the ongoing index turnover will be considerably lower. As the final indices have not yet been built, it is difficult to estimate the transition turnover. However, as the value and growth indices are rebalanced twice a year, the overall yearly turnover including the implementation of the enhanced methodology and the other half-yearly rebalancing are likely to be not substantially different from the average annual turnover with the current methodology.

Q: The style indexes will be rebalanced every six months, at the end of May and November. Why was semi-annual rebalancing selected, rather than say quarterly?

A: The frequency of rebalancing should be carefully evaluated, as it has a big impact on the overall behavior of the index. A higher frequency of rebalancing results in a more accurate index, but it also leads to higher turnover. For instance, quarterly rebalancing could lead to having around 50% excess yearly turnover, compared to a semi-annual rebalancing.

In addition, indices that are rebalanced too frequently are not investable, as they do not correspond to a reasonable holding period or investment horizon of investment managers.

Our research shows that the best trade-off between acceptable turnover and accuracy of the index is the semi-annual rebalancing.