John Spence

Start Your Engines! - MSCI to Release New Index Constituents

The starting gun is cocked and ready for the biggest overhaul of an equity index series in history. Tomorrow, May 19, at 7:00 a.m. Eastern Daylight Time, Morgan Stanley Capital International (MSCI) will release the constituents of the MSCI Provisional Index Series and their inclusion factors. The MSCI Provisional Indices will be calculated beginning May 31, 2001.

But before we get into the ramifications of this announcement, it is first necessary to understand how and why MSCI is switching its indexes to free-float weighting.

What is free-float? Is that some kind of tricky naval maneuver?

No, free-float weighting is a method for assigning a stock's weight in an index. Under the free-float methodology, a company's weight in an index is determined by the number shares that can actually be bought and sold by investors, which excludes shares held by governments and company insiders, for example.

MSCI is switching from market capitalization weighting to free-float weighting (the last major index provider to do so, although it should be noted that the S&P 500 is not float-weighted).

"It's something that should be done," says Wayne Wagner, chairman of the Plexus Group, a Los Angeles-based transaction process adviser to investment managers, plan sponsors, and brokerage firms. "If stock is semi-permanently in closed
hands - cross holdings, government holdings, or management - it shouldn't be counted as market assets. Otherwise you get liquidity pinches as too much money searches for too little available liquidity."

Also, MSCI will broaden its indexes to cover 85% of the market capitalization from the current 60%, a move that will be completed in stages. For the gory details, check out my article from December, when MSCI made the formal announcement.

OK, now I get it. So what happens now?

Well, it depends on who you ask. But one thing is for sure: with an estimated $3 trillion invested in index funds or portfolios benchmarked to MSCI indexes, there will have been massive global stock turnover by the time MSCI completes the second half of the switch on May 31, 2002. MSCI is softening the impact by enacting the move in two stages over a one-year period. Still, hedge fund managers are licking their chops in anticipation.

But the transition will be especially painful for passive investors with assets tracking MSCI indexes. For example, Goldman Sachs estimates that $200 billion of passive money is tied to funds that track the MSCI EAFE index. Barclays Global Investors estimates that the round-trip turnover caused by the switch to the new float-weighted MSCI EAFE will be 29%, and others including Goldman Sachs, Merrill Lynch, and Deutsche Bank have estimates in that ballpark.

Generally, when a stock is included in an index with a large amount of assets tracking it, its price is artificially inflated as index fund managers and portfolio managers benchmarked to the index buy up the stock during rebalancing to reflect the changes. Research demonstrates the reverse is also true when a company is booted from an index. Speculation can compound the problem.

You may have heard the argument that running an index fund is so simple that even a monkey could successfully hold the reins. Granted, low turnover within an index and knowing what the component stocks must be does lead to a lot of thumb-twiddling in comparison to the frenetic pace of running an actively-managed fund. However, rebalancing to reflect index changes is no walk in the park. Passive managers are required to closely track an index, so they all end up buying and selling together when index changes are announced. The ensuing flurry of activity can wreak havoc with stock prices and leads to increased volatility, and is sometimes called the "index effect" because the stock's price fluctuation occurs as a result of being added to or deleted from an index, and demand increases or dwindles accordingly.

What will managers do?

Fund managers have several options because MSCI is enacting the changes over time. A small number have jumped the gun and rebalanced their portfolios ahead of tomorrow's announcement.

Asset managers can make the changes immediately after MSCI makes public the new index constituents tomorrow. Another option is to phase in the changes over time. Since the Provisional Index will be available until the MSCI indexes are fully adjusted for free-float, managers can spread out transition risk with several "mini-rebalancings."

Yet another option is to simply delay and implement the changes when MSCI makes the adjustments in November 2001 and May 2002. To be sure, most managers will not want to wait around until then and endure the possible buying and selling frenzy.

The remaining option is to chuck the MSCI indexes altogether and adopt existing free-float indexes. Salomon Smith Barney, which has had free-float weighted indexes since 1989, has been urging investors to switch over from the MSCI EAFE to its comparable Primary Market Index (PMI). Index provider FTSE was nice enough to send out an announcement today alerting folks of tomorrow's MSCI announcement. Of course, FTSE noted that it has partially adjusted its indexes for free-float since their inception and will be completely free-float adjusted as of this June 15.

On a side note, it's been interesting to watch the mudslinging and spin among the major index providers concerning this issue. Salomon in particular has been churning out research reports for months that depict the MSCI switch as an apocalyptic event, complete with the Four Horses of Turnover trampling passive investors worldwide.

Rivalry has always been present in the clubby world of index design and maintenance, but it's always been subtle, even fraternal, in nature. Now, with the preeminent player in international equity indexes caught in a moment of weakness, the competitors have not been shy about taking their shots.

But that aside, the real losers here are passive investors with money tied to MSCI indexes, whose returns will be affected in the next year as the move to free-float weighting is enacted. At the very least, they must be aware that big changes are in store for the MSCI EAFE, and that there are several strategies for attacking the problem. Indeed, many passive investors may end up scratching their heads this year as index funds designed to track an identical MSCI index post dissimilar returns.