Increased liquidity fuels competition

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Increased liquidity in the international equity markets is driving innovation and intense competition between index providers in what used to be a sleepy corner of the financial industry.

MSCI Barra has revealed plans to change its two sets of global equity indices – MSCI Standard and Small Cap – to a new single set of Global Investable Market Indices.

The two-phase transition includes an overhaul of the stock selection process, size segregation to remove an overlap between the two indices, and the inclusion of emerging markets in the small cap index for the first time.

MSCI claims the new methodology reflects the changing nature of international equity markets and the evolution of investment processes globally. It aims to provide a broader coverage of the investable equity universe.

However, the changes have come under scrutiny from all corners of the indexing space because of the potential for rebalancing activity from passive and active managers, with some $3,000bn benchmarked against the MSCI indices.

It is the second time in six years that the US-based index provider has given a facelift to its coverage and underlying methodology, having switched to free float-adjusted market capitalisation in 2001.

Vijay Sumon, derivative analyst at HSBC, says the new methodology results in significant turnover for no real benefit. “They are forcing index followers to change the composition of their portfolios at a considerable cost,” he says.

“We estimate that for a typical portfolio of about $100m, it will cost about 0.5 basis points of the value of the portfolio for developed markets large and mid-caps.”

Competitors claim the transformation is merely an attempt by MSCI to stay afloat in an evolving and highly competitive market.

“It’s positive that they’ve recognised there were issues with their construction and they’re doing something about it,” says John Davies, senior director, business development, at Standard & Poor’s Index Services.

“This set of changes for MSCI moves them forward and towards FTSE and S&P, but it doesn’t get them all the way, so I would question how long it will be before they make another change.”

MSCI’s global head of the equity index business, Ted Niggli, supports the transition plans. “I’m not surprised the competition would say something like this because they’re obviously trying to gain some of these assets,” he says.

“But because of the detail we have put into this, what we’re hearing from our clients is that they are overwhelmingly satisfied with what we’ve done.”

Giacomo Fachinotti, chairman of the MSCI Equity Index Committee, adds: “The transition to this enhancement results for the ACWI (All Country World Index) in a one-way index turnover of 3.4 per cent, which is modest. It is the equivalent of the average turnover in the annual rebalancing over the last three years.”

With the MSCI revamp comes the recognition of a convergence of global equity benchmarks.

Bernard Nelson, principal at Mercer Investment Consulting, says: “Each time one of them moves, they move closer to each other. They’re trying to be as representative as possible and to iron out anomalies that used to take place, such as the distortions that existed before free float-adjusted market capitalisation.”

Indeed, the distinctions between providers are blurring, making it harder for pension scheme trustees to decipher which benchmark best suits their needs.

The Russell Global Index covers 98 per cent of the investable global market and is divided into a family of indices covering 63 countries. Kelly Haughton, strategic director, says the sole cut-off between large and small caps across both developed and emerging markets set the firm apart from other index providers.

“If you’re a global investor, you look at large and small cap distinctions on a global basis, not a country relative basis,” he says.

Both the FTSE Global Equity Index Series (GEIS) and the Dow Jones Wilshire Global Index Family also target 98 per cent of the investable market capitalisation, however in Dow Jones’ case, this reduces to 95 per cent for the emerging markets.

When the transition completes on May 30 2008, MSCI will cover 85 per cent of the free float-adjusted market capitalisation in each
market for its standard indices, and 99 per cent of the investable equity universe for its small cap indices.

The number of countries covered in the equity indices ranges from 48 (FTSE) to 63 (Russell), with different liquidity screens.

Paul Grimes, chief operating officer at FTSE, says: “We’ve developed a rigorous framework for country eligibility. We don’t just look at gross national income or the relative size of the market; we have 22 specific criteria that are transparent to both investors in those markets and the markets themselves.”

Clearly the philosophy behind the providers’ approaches varies, with MSCI attempting to strike a balance between size, integrity and country coverage.

The trade-off between investability and comprehensive coverage is where disparity between providers is most apparent.

Mr Davies does not believe it is possible to have a benchmark that meets both of these demands.

“A benchmark is supposed to represent the universe, whereas if you want a highly investable, tradable index, then by definition you’re going to have a much narrower universe of securities,” he explains.

“If you’re looking at global equity portfolios, I don’t think you can have one index that meets all of those requirements.”

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