An index for Europe
The fundamental changes in the European investment environment ushered in by the creation of the single currency are stimulating demand for new indexing products. Rachel Fixsen examines what will be on offer
Next year the shape of investment in Europe will change forever. Exactly how is still far from clear, but index providers are already out in force with a battery of European stock index products to cover every possible new investment scenario.
The idea, of course, is that when the single currency takes effect, investors will have little reason to stick to their domestic equity and bond markets and may treat the entire zone where the euro is used as their home market. Currency risk will no longer be an issue, so investors from the 11 countries due to adopt the single currency in January will be able to match domestic liabilities with assets in other stock markets in the euro zone.
And it has become accepted wisdom that European equity portfolios will make a slow transition, no longer divided by national market but instead split up into industrial sectors.
This much-heralded switch to sectoral investment in Europe is already happening, and it is apparent in the way European markets behave, observers say. Sectoral weightings can now affect differences in performance just as much as the domestic market mood.
Financial products based on European sectors are already available and aimed at managers focusing on an industry rather than a national market. Morgan Stanley Dean Witter markets Opals, securities backed by a basket of stocks which aim to track MSCI European Industry Indices.
Index creators have been watching the new trend unfold. European Benchmarks is a joint venture between Belfox, the Belgian futures and options exchange, and Belgian data vendor Tijd Electronic Services. European Benchmarks produces a range of pan-European sectoral indices, which it calls Insects. Rather than defining an industry sector by using commonly accepted economic divisions, as established index providers do, it forms an index by watching the market and then pinpointing stocks that move together consistently.
Already, national indices within Europe are showing signs of increasing correlation, says Jonathan Gollow of European Benchmarks, and gradually there will be a reduction in the correlation of sectors.
New patterns of behaviour in the financial markets call for new derivative products and this has been the driving force behind the providers' race to bring out new indices. The money providers stand to make if they beat off the competition seems limitless. When a derivatives exchange licences a certain index as the underlying for futures or options, it pays the index compiler not only an upfront fee, but most importantly an ongoing fee based on turnover.
Turnover in products linked to European indices is still low, but rates of growth already seen are marked. Both the London International Financial Futures and Options Exchange (Liffe) and the Eurex consortium have announced plans to launch derivative products based on pan-European benchmarks.
Another major source of revenue for the compilers comes from financial institutions marketing index-linked investment products such as equity-linked bonds and, most importantly, tracker funds.
Tracker funds are increasing in popularity, and not just in the retail investment market. In UK equities, pooled and segregated pensions funds both underperformed their main benchmarks last calendar year, and this has raised more questions as to the value of active management.
Index funds are huge in the US," says Bill Jordan, director of communications at Standard & Poor's. "Nearly $700 billion in the US is indexed just to the S&P 500." However, the tide of opinion may change. If markets enter a bearish phase now, active managers may be proved to outperform their passive counterparts, pouring cold water on the argument in favour of trackers.
Sandy Rattray, an analyst at Goldman Sachs, says he is convinced European investors will make the move from domestic portfolio management to Europe-wide fund management, but not as rapidly as some people think.
So far only a very small number of investors have shifted their domestic portfolios to European ones, but more will do so next year when the euro is actually launched. And big portfolios tend not to move rapidly anyway, he notes: "They may take at least a number of years to reflect the change in style."
There are also tax implications of any major change in strategy. "You can potentially realise quite large capital gains... so that's the first thing that might slow you down," he says.
And it is unlikely fund managers will immediately want to drop shares in companies they have followed for years, however convincing the arguments may be for stepping up their cross-border diversification.
Steven Vale, policy and communications manager of FTSE International, agrees that though funds will realign towards a more sectoral approach, changes in the way fund managers invest within Europe will not happen overnight. And until political integration happens too, the investment realignment will only be partial.
"Country differences will still play a role," he says. The 11 countries due to join the single currency in January will eventually have banknotes and coins in common, but there will still be 11 different tax regimes for investors, markets and issuers to contend with. "I don't believe investors will see a German equity as identical to a Portuguese equity."
Index providers, like European Benchmarks, are ready for the sectoral approach to gain popularity. But there appears to be no consensus on exactly what constitutes a sector in the financial markets. Index providers Dow Jones STOXX and Morgan Stanley Capital International (MSCI) have individual indices for sectors within Europe. But STOXX has isolated 19 sectors, while MSCI has indices tracking 38 industries. FT/S&P has 36 industry groups for its indices, which are split into 97 sub-sectors.
The Insects method of examining trading correlations between stocks before defining a sector can sometimes produce surprises. Gollow says the most recent Insects index to be launched, telecommunications, obviously included giants such as Ericsson and Nokia. But compilers found that Dutch electronic group Philips also moves very closely with the sector, although the stock would normally be grouped with consumer electronics or consumer goods, Gollow says.
Each of the index creators now jostling for position dreams of their own benchmark emerging as the most widely recognised measure of stocks performance across Europe. But the kudos of having an index quoted on television news, as the Dow Jones Industrials and FTSE 100 are now, is only part of the prize.
Credible indices can be profitably licensed as the basis for derivatives products such as futures or options contracts. With fees based on the product's turnover, profits in the long-term could be huge.
Daily volume in Liffe's FTSE Eurotop futures contract has already more than doubled to 440 from 200 since its launch. This is still a far cry from turnover in FTSE 100 futures, which stands at about 30,000 daily.
Main adversaries in the equities benchmark war are emerging as FTSE International, Dow Jones and Morgan Stanley Capital International (MSCI). These providers have the advantage of already being widely recognised and accepted for stock indices.
The sparring indices can be divided into broad market indices, which aim to reflect the performance of the entire underlying market and narrow or blue-chip indices which have the advantage of being more liquid. Among suppliers of broad market indices are MSCI and Financial Times/Standard & Poor's Actuaries (FT/S&P). Their widely-used indices have been joined this year by STOXX, a joint venture between Dow Jones, and the German, French and Swiss exchanges.
Narrow indices include the FTSE Eurotop 100 - which is calculated as a joint venture between FTSE International and the Amsterdam Exchanges - MSCI Europe and STOXX 50.
Standard & Poor's has recently joined the market for European indices with its S&P Euro and Euro Plus indices. It is part of S&P's strategy to build a global series of indices adopting the same methodology as the widely-used US domestic equity benchmark, the S&P 500. "We expect this new index to be an integral part of the the evolving battle of the benchmarks," says Barclays Global Investors in a report.
Unsure exactly what the effects of the single currency will be on the shape of investment in Europe, index suppliers have been hedging their bets by creating several different types.
The main area of uncertainty is whether an index covering all of Europe will be called for or one which simply covers the 11 countries participating in the single currency from the start. All of the broad market indices and blue-chip indices are available on a pan-European basis as well as as a euro zone basis.
One disadvantage of an index that only covers the 11 countries entering currency union in January 1999, is that certain industry sectors within Europe become largely excluded. For instance, much of the pharmaceuticals industry is domiciled in the UK and Switzerland.
Also, as Morgan Stanley Dean Witter points out in its analysis of European indices, Europe as a whole has a much higher weight in the consumer goods sector than does EMU alone, largely because of the heavy concentration of health and personal care stocks in the UK and Switzerland. "EMU on the other hand has a much higher weight in the energy sector," the report says.
So sector exposure is skewed by any index solely using euro zone stocks, but on the other hand a euro zone index does provide a good fit for currency and regulation. It also is more of a small-cap index since over half of the Eurotop 300 is made up of UK stocks.
Another point about any euro zone index is that its base is almost certainly going to change over the next few years as more European countries join the single currency. "So it could be a fairly turbulent time for those using EMU index-based products," says Jonathan Seymour, head of equity product development at Liffe.
S&P's Jordan says that of the two choices of European index S&P is launching (eurozone and Euro Plus), he expects the Euro Plus, which includes Denmark, Norway, Sweden and Switzerland, to be the most widely used.
There are some big differences between the broad market indices offered by the three providers, Morgan Stanley notes in its report. The most obvious is the weighting that the UK is given, with the FT/S&P Europe giving the country a 32.9% weight. The MSCI Europe gives it a 30.2% weighting and STOXX gives it 29.6%.
Certain sectors, too, play a greater or smaller role depending on the index. Capital equipment makes up 9.0% of the MSCI Europe, but only 7.6% of the FT/S&P Europe. On the other hand, financials have a 29.6% weighting in the FT/S&P Europe but only 26.5% in the STOXX index.
Another area of concern, particularly for users of derivatives products using these indices as a basis, is the tracking error of the individual benchmarks. "Tracking errors move anywhere between 2 and 4%, depending which pair of indices we compare," says Dominic Huou of Merrill Lynch.
According to an analysis by Goldman Sachs - one of the joint owners of the FT/S&P indices - the tracking error of the Eurotop 100 against most established benchmarks is as much as 40% lower than for the STOXX 50. However, the report also notes that most of the tracking risk of the STOXX 50 futures comes from country allocation differences, and industry risk is a lower component of risk for it than it is for FTSE Eurotop futures.
It is too early to decide which of the indices will win the battle for general acceptance in the European market, most in the industry agree. Not all of the players have shown their faces yet, and no one yet knows just how EMU will change investment behaviour and demands."