Fund managers like to moan about Morgan Stanley Capital International (MSCI) and its damned indices. As the region’s most high-profile index provider, MSCI is never far from controversy. Earlier this year it re-admitted Malaysia to its all-Asia ex-Japan free index and doubled Taiwan’s weighting. These kinds of changes force index managers and those who benchmark against them to follow suit, sometimes at great cost.
Vincent Duhamel, CEO at State Street Global Advisors Asia in Hong Kong, which manages approximately $400 billion in index funds, says he and other indexers are most vulnerable to these kinds of changes. Other fund managers know exactly what his positions will be. “They line up their trades like ducks,” he says, holding up his hands as a hunter positions his rifle. The growing tendency of active fund managers to benchmark against indices just adds to the carnage.
“Please, index more,” mocks Andrew Alexander, director at The Pacific Group, a Hong Kong-based hedge fund. The herd mentality among traditional fund managers distorts markets and gives absolute-return players such as he room to make a killing.
The mother of all index changes occurred in Japan this past April when the Nikkei 225 index, which is tracked by Japanese investment trusts (mutual funds), underwent an unprecedented rebalancing involving 30 stocks. The ensuing chaos left an enduring taste of bitterness – and a handful of brokers stinking rich.
Trade of the century
The profits rumoured to have been amassed on 24 April are mind-boggling. Indeed, the Nikkei reweighting may have created the biggest payday in history. Firms such as Deutsche Bank, JP Morgan, Lehman Brothers and Merrill Lynch each reportedly racked up profits of $100 to $130 million. Local players such as Nomura Securities are said to have made several times that amount. The losers? Japan’s retail investors, and the credibility of the Nikkei 225. (The above firms declined to be interviewed for this article, or to comment on their reported profits.)
The path to such unusual trading glory is common: the volume weighted average price (VWAP) trade. Nikkei announced the change a week beforehand. Brokers knew what 30 stocks were to be dropped, and the other 30 stocks to be added. Say the price of an impending entrant stock is Y800 ($7.42). Brokers call their customers and promise them a return of Y1,200 after the trading day. As all the funds tracking the index rebalance over the course of the day, there is a run-up on the prices of all the new stocks. The brokers peg the VWAP price (Y1,200) below their real expectation for that day’s closing price (which turns out to be, say, Y1,500). The brokers take home the difference between their promise and the real closing price. At the same time they are throwing their prop desk’s entire balance sheet at this thing.
Although it is possible for the market to turn against you if a lot of people sell, brokers know the funds tracking the index are obliged buyers, so it’s not too risky. Furthermore, for a player at the heart of the market such as Nomura, which knows that its sheer volume of orders will have an impact on price, it can make even bigger, more aggressive trades.
The VWAP trade originated in the United States, where indices are so prevalent. They began to be utilized in scale in Asia when MSCI announced it would eventually raise Malaysia and Taiwan’s country weightings, and again when MSCI dropped Cheung Kong from its Hong Kong country index. What is unique about the Nikkei 225 trade was its scale – switching 30 stocks on one day is akin to, say, shifting 60 stocks in and out of the Standard & Poor’s 500 in New York.
Nikkei’s intention in April was to bring the Nikkei 225 up to date. The index hadn’t changed for nearly a decade and was falling into irrelevancy. Takashi Kawahara, deputy general manager of index operations at Nihon Keizai Shimbum (Nikkei)’s electronic media bureau, explains the share switcheroo was a result of a change in Nikkei’s rules. “The substance of the matter is the rules,” he says. The idea was to catch up with the new economy. “We didn’t know if the information technology revolution was for real, but last year it became clear, as traditional companies began using IT.”
He says Nikkei decided not to stagger the changes because it would be criticised for fuelling market speculation about upcoming switches. Index fund managers, however, agree that gradual changes give the market time to digest them; “big bang” approaches are far more disruptive. This is a reflection of Nikkei’s amateur status. It is a newspaper publisher and it runs the Nikkei as a value-added piece of that business, instead of as a profit centre. Market players are critical of this approach, however, because so much Japanese retail money rides the Nikkei 225.
The irony is that by trying to keep pace, the changes ultimately did Nikkei no favours. Its timing was bad: the rebalancing occurred at the same time as Microsoft was losing a court battle in the US and the Nasdaq began to plummet. As a result, the Nikkei ended April 24 down. This caused Finance Minister Kiichi Miyazawa to criticize the rebalancing because the last thing the government needs is to lose more credibility over poor equity markets.
More: the Nikkei 225 is still out of alignment with the markets. Its tech weighting has overshot from 17% to 34% of the index, going from one extreme to another. It is also a more volatile index, with the new constituents’ 6-month volatility calculated as 25.5%, versus 16.0% for the old line up, according to research by Morgan Stanley Dean Witter.
Worse: local newspapers leaked news that the Securities Exchange Surveillance Commission in Japan has launched an investigation over possible insider trading related to the rebalancing. When asked whether any Nikkei officials have been queried by the Surveillance Commission, Kawahara says, “I have no first hand information. I can’t answer this question; the Surveillance Commission will never say in public whether it is pursuing an investigation or not.”
Strangely, because of Nikkei’s amateur character, the publisher is uninterested in keeping up with international trends, such as moves toward sector indices or adjusting indices to account for free floats. Kawahara notes the company has never actively promoted the index. “If market players want to use it, fine, but we won’t aggressively urge clients to do so,” he says. Indeed, Nikkei sees these changes as fads. Several years ago it hoped to take advantage of Japan’s sorry stock market and introduced an index based on value stocks; it was a flop.
Nikkei will continue to rebalance its 225 index, however. It is supposed to do so every autumn, and last month it made six stock changes, half of which were to account for the debut of Mizuho Financial Group, the result of a triple merger between Dai-Ichi Kangyo Bank, Industrial Bank of Japan and Fuji Bank. Nikkei’s systems are not up to the job; the transfer was not seamless but took place over a week, leaving the index officially the Nikkei 222 for a few days.
If Nikkei seems hopelessly outdated, the same can not be said of MSCI. Lambasted for its treatment of Malaysia and Taiwan, which originally were to be reweighted in May all at once, MSCI backed down against investor anger and graduated those processes. It has learned its lesson.
MSCI’s next move should not give brokers another crack at gobsmacking trading profits. But it will be far more important. And, curiously, the biggest impact is likely to be on that misfit of indexing, Japan.
A real index
The problem all equity indices face is that they don’t adjust for free-float. Indices were developed in the US, where the government’s role in listed companies is nil and where conglomerates such as General Electric tend not to list their subsidiaries. This is not the case in the rest of the world.
The status quo creates share price inflation for certain stocks. Take, for example, NTT DoCoMo, a subsidiary of Japan’s Nippon Telegraph and Telecommunications, both of which are listed on the Tokyo Stock Exchange. NTT DoCoMo is huge, accounting for a whopping 6% of TOPIX, but only 2% of its shares are available to investors. They must all make NTT DoCoMo 6% of their portfolio, however, creating a permanent shortage of the stock. “NTT DoCoMo’s share price is not explained by fundamentals,” says one analyst. He adds that although this is a universal problem, it is uniquely intense in Japan (other Asian markets suffer from overbearing government ownership). MSCI includes NTT but not NTT DoCoMo in its indices.
To date, MSCI has tried to dance around this problem by excluding companies that own one another from both being members of an index, or by including operating companies rather than holding companies. This policy led to the recent dumping of Cheung Kong (which gave traders such as Pacific Group a wonderful opportunity to make money at the expense of funds tracking the index). MSCI does account for free floats in developed markets by excluding stocks with a free float of below 25%. But these are half-way measures.
Indeed, MSCI is playing catch-up. Dow Jones has already begun implementing free-float adjustments for all its indices (except the DJIA), while S&P has already been making partial adjustments. The Financial Times has already announced it will fully adjust for free floats by summer of next year. Fund managers in Tokyo say TOPIX is also studying such a move.
Eric Michel, president at State Street Global Advisors in Japan, notes these sea changes and the resultant market turnover present opportunities for rival index providers. “It’s clearly a question on the table,” he says. “It re-opens the competition among indices as MSCI goes toward a Footsy-like methodology.”
In order to make its products more investable, MSCI has released a consultation paper proposing to free float-adjust all index constituents; to increase the target market representation of indices from 60% to 80% of each industry group in each country; and to phase these changes in very slowly.
MSCI is considering several strategies to implement these goals. One is to include each stock exactly based on its free float, but this would create huge turnover and would be difficult to maintain without constant adjustments. Or it could extend its current policy of only including companies with a certain percentage of free float to emerging markets, but this would ignore the problem of cross ownerships. Most likely, MSCI will sacrifice some level of investability and opt to weigh stocks somewhat greater than their free float. It is defining this level of wiggle room that MSCI and its clients are likely to have a feisty discussion over the coming months.
To compensate for this less than perfect solution, MSCI is proposing to broaden most of its equity indices to account for 80% of a market cap of each industry group, up from 60%. By adding names to indices, MSCI also hopes this will reduce the need to rebalance stocks in the long run.
This move could create problems for investors, particularly when dealing with emerging markets, says Dan Fineman, strategist at Jardine Fleming in Hong Kong. “Investors are averse to small, illiquid stocks. This will make life more difficult for large funds,” he says.
But one of MSCI’s biggest customers, Barclays Global Investors, supports the move. Steven Schoenfeld, their strategist in San Francisco, supports the proposals. “It reflects the current state of the art of constructing indices and the reality of what an investor can purchase,” he says. The tricky part will be implementation: “Our position is the optimal path is a parallel implementation: you continue to calculate the current index. Let’s say you announce the new index and its constituents in, for example, May, while maintaining calculations for both. This gives the industry time to get to know the new index.
“Then six or nine months later the new index becomes official – but you can still continue the old one. Different users such as plan sponsors or active managers can then choose their own time to make the switch, so as to minimize the market impact. You can’t have a big bang approach like the Nikkei changes – that was unexpected and extreme. I don’t mean to sound like Tony Blair but a third way approach is the most beneficial.”
As for dealing with small caps and illiquid stocks in an expanded index, Schoenfeld says BGI is discussing a “liquidity screen” with MSCI and addressing a number of operational issues. Joe Leung, quantitative analyst at Dresdner RCM Global Investors in Hong Kong, adds while some illiquid stocks could be difficult to handle, it means better diversification and ultimately is good news for some worthy companies who have gone ignored by large fund managers.
So for once investors aren’t griping about MSCI. But what does this move to free-float adjustments mean for Asia? For most markets, surprisingly little. A recent research paper by Goldman Sachs finds MSCI announcements in the past three years have had no discernable impact on the market outside the fortnight around the rebalancing. Fundamentals quickly reassert their authority, says Goldman.
But for Japan, it is a different story. ING Barings forecasts the high level of corporate cross-holdings will result in an outflow of $122 billion of funds, making it the biggest loser worldwide. A report by Morgan Stanley Dean Witter confirms this worry. It predicts Japan’s weighting in the MSCI Europe, Australia and Far East index will fall from 26.46% to 22.69%, resulting in a net outflow of $5.8 billion by passive investors, not counting active managers tracking the index..
Not all agree with this ominous scenario. Leung notes there will be plenty of buying, as investors leap at names such as NTT DoCoMo, Yahoo! Japan (owned by Softbank) and Matsushita Communications (owned by Matsushita), which will now be included in the MSCI roster. He adds that comparatively Japan isn’t in bad shape – it’s free float is higher than most of Asia, and is middle-of-the-road on a global scale.
Regardless of the impact on fund flows, the trend by index vendors will have a huge impact on cross ownership in Japan, particularly once TOPIX also adjusts for free floats. Cross ownership has already begun to decline with the erosion of the stock market. The downgrading of financial institutions and the urgent need for institutional investors to improve performance has led them to shift out of relationship-driven strategic holdings and allocate more to foreign fund managers. Bankruptcies are also forcing institutions for the first time to mark to market, another blow to cross-shareholdings. Index charges will accelerate this process.
