The impact of cross border mergers and the dramatic spurt of the TMT sector during the first six months of this year is having an effect on index providers. In many markets a few stocks have come to dominate the indices, bringing with them the attendant problems for fund managers tracking a benchmark and subject to restrictions on holdings by the regulator or their own trust deeds.
The recent merger between Vodafone Airtouch and Mannesman meant the stock leapt above the 10% mark for the FTSE 100 basket, prompting FTSE to introduce a capped index in May, to run alongside the established index. The company confirms that the new index has been designed with fund managers in mind, and that the 10% cap was chosen in the light of European restrictions on unit trust managers holding more than 10% of their portfolios in one stock.
No such restrictions, other than those found in trust deeds apply to pension fund managers, and to a certain extent it is not such a major issue, as typically a European fund would hold no more than 50% of its funds in equities, making even a 10% single issue restriction almost redundant.
Nevertheless, across European markets the application of a cap to particular stocks can be an arbitrary business. For some time now the Dutch AEX and the Finnish Fox have been operating caps. In Amsterdam, however it is set at 10% whilst the Fox cap is double that. Recently the NDX has introduced a two-tier adjustment applying to any individual stock whose weight exceeds 24% and to a group of leading stocks once they jointly account for 48% of the index.
When the Dutch introduced their index in the mid 1980s it was decided to cap it on the basis that otherwise Royal Dutch would far outweigh every other stock and distort the index. “Since that time we have traditionally set cap values, all at 10%, on every new index which we have introduced,” says Raymond Salet at the Amsterdam Exchange. “Nowadays it is more for the benefit of the investor rather than worries about distorting stocks.”
At the other end of the scale, despite recent pressure from institutional investors, the Madrid Bolsa has shown little interest in change. The massive privatisation programme, introduced by the Partido Popular government of José Maria Aznar, has resulted in some large companies arriving on a relatively small and illiquid market. That, combined with the opening of the doors to European investment, has meant that financials and the telecom sector have begun to dominate. Nonetheless, the Bolsa remains resistant to overtures for a capped index.
This lack of consistency spreads across Europe with the German Dax operating a 15% limit whilst Euro Stoxx 50 has a 10% cap. Even recent additions such as the OM Stockholm Exchange and the Paris-based Itcac vary with limits of 20% and 10% respectively. Bruno Rossignol at the ParisBourse says that the Itcac is not proving very popular. “We settled on a 10% cap with unit trust managers in mind, but so far as popularity is concerned whether an index is capped or not is not the issue. What matters is what stocks are in the index and whether it truly reflects the sector or economy it purports to be representing.”
Rossignol believes that most fund managers will buy options to overcome problems with outperforming stocks rather than rely on tracking a capped index. However, interestingly Euronext (the on-going merger between Paris, Amsterdam and Brussels) will be launching indices in the Autumn, and all of them will be capped. “We tend to take more into consideration what fund managers say, and they are insisting on having capped indeces and so we are trying to please them.”
In a recent report, Sandy Rattray, equity derivatives analyst with Goldman Sachs, highlighted some of the problems for managers with capped indices. He points out that the rebalancing of stocks is carried out on an arbitrary basis, matching the nature of the caps themselves. “What is the correct level for a cap, 10%, 15%, 30%? The re-weighting of the stocks can also mean that an investor with a capped benchmark can be doing far more trading as he tracks the changes,” he says.
While pointing out that capped indices are difficult to replicate he also accuses that they reject market efficiency, suggesting as they do that it is possible to allocate capital better than the market.
He agrees with Rossignol, however, that fund managers can deal with over-performing stocks by selling call options on the portion of the stock above the percentage. This could mean continuous selling if the shares are strongly over-performing, meaning that the fund receives premium income from the sale of the call option, being paid for making a sale that would have had to be made if the portfolio was managed in accordance with index weights.
As no index re-weights constantly however, most fund trustees adopt a pragmatic view, limiting holdings to a percentage at the day of purchase, or requiring them to adjust monthly or quarterly. The cost of continuous tracking would make this an impractical venture. As Peter Lockyear of Merrill Lynch Mercury points out, the situation is different for unit trusts with their statutory limits on holdings. “Capped indices accurately reflect the investment universe for those funds, which make them a better tool than any other for those funds.”
Andreas Brodtmann, portfolio manager with Berenberg Bank in Frankfurt, points out, “We prefer to work with capped indices, where at least we can be as close to our desired sector position as possible. In Germany, for instance, where the Dax has a 15% cap, Deutsche Telecom is obviously a desired stock. As we are limited as a mutual fund to 10% of that stock we can look around for alternatives to get our sector weighting right, even if we have to underweight in the leading stock. In smaller markets such as Greece and Hungary, for example, where no cap operates, a leading stock may account for up to 25% of the index, and there will probably be few or no alternatives. This means we simply cannot invest in the outperforming stocks.”