Globalisation is blurring national borders and making them less relevant for investment decisions.

The move by mega-countries China and India from socialist to capitalist systems is introducing change and new opportunities. Austrian economist Joseph Schumpeter foretold as much. He called the creation of new markets and obliteration of old ones the process of Creative Destruction. Change, he said, is capitalism’s essential fact. And if indices don’t respond to change, they become useless.

Company vs country

Some country-relative index providers constrain country membership, then make ad hoc decisions on when to add a country or when to move a country from one index to another. This results in companies that are investable being left off. A leading world index leaves off five companies from Kuwait, Slovenia and Lithuania, with market capitalisations ranging from $2.7bn to $4.9bn. Ignored are Mobile Telecommunications Co, Kuwait Finance House, National Bank of Kuwait, Krka DD Novo Mesto and Mazeikiunafta.

Country-relative indices also tend to misrepresent company size. New Zealand mass merchandiser Warehouse Group, with a market capitalisation of $775m, is considered “large cap” in its home country. But a global-relative assignment puts it in perspective as a small cap.

Just as borders are becoming blurred, so is the distinction between emerging and developing markets. When some index providers designate a country as emerging, then all the stocks associated with that country are considered “emerging market”. This potentially misrepresents some stocks and limits an index’s ability to represent the investment quality accurately of a country’s market as a whole.

Similarly, moving countries to “developed” status within an index family means all the country’s stocks are deleted from the emerging market index and added to the developed market index (affecting all associated index funds). Turnover costs may cause index providers to hesitate in making a change of this magnitude, inaction that distorts that index’s accuracy.

A better approach to this dilemma is to look at companies instead of countries, the same as investors. Global investors choose stocks based on industry exposure and company fundamentals regardless of home country.

Samsung is one of the 70 largest companies in the world and one of the 10 largest companies in global technology. It does business in more than 100 countries. But because Samsung is based in South Korea, it is considered an “emerging market” stock by other index providers.

Company vs sector

Market indices should not constrain membership by sector, whether by arbitrarily leaving some companies off or failing to add new ones in a timely way. Combined with annual reconstitution, this tends to represent new industries earlier than other index providers. Russell Investment Group was the first to include financial exchanges – NYSE and Chicago Mercantile Exchange – in its index family.

Many index providers only sample market companies in their indices, so are forced to make security selection in certain industries to simulate sector exposure.

Sampling by sector-based indices often excludes notable investment opportunities. Sector-based indices excluded premium carmaker BMW because they were already “overweight” in German auto stocks. Other exclusions have included Korean chip maker Hynix Semiconductor and Nasdaq.

Global Approach

The most efficient approach to index creation ensures companies are added to indices when they become investable by global investors, not when some arbitrary rule comes into effect.

The number of companies from China, India and Russia has grown over the past few years, while the number of companies from Brazil, Hungary and Mexico has remained relatively constant. This represents the investment reality in these countries.

An annual reconstitution of index membership accommodates the worldwide forces of Creative Destruction that are an essential fact of capital markets. Annual reconstitution and a company-focused approach lead to indices that efficiently and accurately represent the global market. Investors can count on these indices as reliable barometers for evaluating manager skill and gauging index fund performance.

The writer is strategic director, Russell Indexes, at Tacoma, Washington-based Russell Investment Group.

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