Setting a new benchmark
MSCI has at last announced that it will fall into line with the other main stock market index calculators and take account in its index calculations of a constituent company’s free float. This expected change together with sweeping changes in the make up of blue-chip indices such as the FTSE 100 is certainly focusing attention on indices and the benchmarks that flow from them.
At the moment it seems that it is mostly fund managers who are in the driving seat as regards the choice of index and therefore the benchmark against which a pension fund judges its managers. This has always seemed a very strange way for pension funds to behave. The choice of benchmark can have an important impact on a pension fund’s performance so it has always seemed strange to me that so little time has been devoted to the selection of the most appropriate index against which pension funds want their managers to be judged.
This is however changing but it was illuminating to read the results of a consultation undertaken by FTSE in the summer and autumn of 1999. The consultation paper was entitled ‘Setting a Global Standard for Indices’ and dealt with the issues of defining the nationality of companies and the treatment of cross-holdings and restricted free float.
Apparently, over 130 organisations from 17 countries responded with fund managers representing 48% of the response.
Whilst 8% of the response came from actuarial consultants, the response from pension fund trustees was not shown and is presumably part of the 3% response shown as ‘Other’ - a very disappointing response. I have not seen the response to MSCI’s more recent consultation exercise but I would be (pleasantly) surprised if it were significantly different. However the results of both consultation exercises were quite clear with investment professionals wanting to see much more representative indices or ‘investible benchmarks’. Both FTSE and MSCI will now be able to provide these. Of course the way this is done varies from index provider to index provider and who is to say which method is right or wrong.
I do believe, however, that pension funds should spend more time analysing and understanding the methodology used by the indexers. For example, on the question of free float, Salomon Smith Barney has always allowed for it and believes in full free float, not band weighting. FTSE, which implements its free float rules from 1 January 2001, has introduced 25 percentage point bands.
In comparison MSCI will include a constituent’s free float rounded to the closest 5%. Standard & Poor’s on the other hand has full free float in all of its indices apart from its most widely used - the S&P 500. With more than $1trn (e1.14trn) indexed to this index the implications of a change would be horrendous, but the pressure may well come!
In the interests of brevity I shall refrain from comment about Dow Jones Stoxx and apologise to all those other index calculators that I have failed to mention.
One of the consequences of these and other differences between indices is that different indices produce widely different results even when attempting to cover the same marketplace. Whilst the correlation between indices may appear very high, the long term performance difference may well be significant. Ian Toner at Salomon Smith Barney points to a nearly 30% cumulative index return difference in as little as the five years to the end of 1999 between different mainstream US equity indices such as the MSCI US and the Russell 3000 which have a correlation of 0.987.
One of the features of these changes to FTSE and MSCI indices is the long notice period and the possibility of market distortions during these periods. Now we already have quite longish periods between the announcement of changes to the constituent make of indices and the actual implementation of those changes. This can lead to substantial profits available to speculators who sell the shares of the leavers from an index at the point of announcement at the expense of index investors who only move at the date of implementation. These index investors still receive their chosen index return but are often ignorant that the index itself has distorted the market.
It is commonly recognised that shares often surge in anticipation of their promotion to an index but often forgotten that shares about to leave an index frequently lose even more of their value.
The changes that have taken place this year in the make up of the FTSE 100 index have generally mirrored the market but has it really made much sense to have Associated British Foods relegated from the index in March, promoted in June, dropped in September and returned in December. Its direct counterpart is Baltimore, which has been promoted and relegated twice.
One has to ask if all this activity is really necessary and, in particular, whether the investor has profited in any way?