Competition among index providers is as fierce as ever thanks to the popularity of passive management, the introduction of the euro and the surge of the TMT sectors. Mergers producing vast companies valued in tens of billions are also increasing the need for capped and multinational indices. A fifth of institutional money in the US is managed passively and the trend is catching on in Europe.
“Passive investment is growing because it just makes so such sense; it’s good return for less money,” says Jacqueline Meziani, director of global business development at Standard & Poor’s. Standard & Poor’s launched its S&P 1200 index, a composite of six indices including the S&P 500, the Europe 350 and Asia Pacific 100. Meziani describes it as somewhere between what she calls a media index, like the Dow Jones industrial average, and an all-world or ACWI index, in her opinion too broad to replicate.
FTSE also unveiled the FTSE all-world index, a hybrid of the existing FTSE world index and emerging markets data provided by ING Barings. Donald Keith, director of marketing at FTSE, says the provision of global benchmarks is now highly competitive and acknowledges MSCI. “There are two truly global benchmarks. One is the MSCI and other is the FTSE and what we were looking to do was to develop our all-world index to make it much more competitive to Morgan Stanley, by adding emerging markets,” he says.
MSCI is all action and last August launched its global industry classification standards (GICS) in conjunction with Standard & Poor’s. Unlike the FTSE system, the approach is on four tiers. Normally, classification systems operate on only two or three levels but, due to client feedback, MSCI has added a fourth level. GICS comprises 10 sectors, 23 industry groups, 59 industries and 123 sub-industries. Lauren Williams, vice president at MSCI, says the introduction of the industry groups should make day-to-day use easier. Under this system, MSCI is producing indices for the top three tiers.
According to Sally Bridgeland, head of investment research at Bacon & Woodrow, MSCI is more likely to threaten FTSE in continental Europe opposed to the UK. “In the UK they MSCI have a long way to go, they have a very tough battle on their hands. In Europe, it’s more of an open field. FTSE has not traditionally been so strong in Europe and MSCI and other indices have been used more there,” she says. Bacon & Woodrow, FTSE and BGI launched their multinational index in response to the increasing number of genuine multinationals (more than 30% of sales outside the region of domicile).
“There was a need to reflect the growing number of companies that didn’t fit comfortably within a country index,” says Bridgeland. Multinationals have different characteristics to UK companies and Bridgeland says creating two separate sectors help to control risk. The spate of large mergers – such as Glaxo Wellcome/ Smith Kline Beecham or BP Amoco – creating vast companies led trustees to question whether their benchmarks were incurring risk. The US market is big enough to absorb the products of such mergers. Microsoft, for example, represents 2% of the market, but in the UK and Europe it’s different. “When you have these multinational giants within smaller countries’ domestic markets, they suddenly look out of proportion and that has been a problem if you have a lot of your portfolio in that one index; typically the case for UK and European pension funds,” says Bridgeland.
These mergers, like that between Vodafone and Mannesmann, have led FTSE to launch new indices the FTSE CAP 100 and FTSE CAP All-Share earlier this year. The two are similar to the FTSE 100 and FTSE All-Share but not replacements. Stocks in the new indices will be limited to 10% of the total and the indices will be calculated on an end-of-day basis. The indices will also be reviewed and rebalanced on a quarterly basis. Mark Makepeace, managing director of FTSE, says market concentration, due to privatisations and cross-border mergers, is behind the indices’ creation. Nokia, for example represents about 65% of the Finnish market, Deutsche Telecom 20% of the German market.
One of the hottest topics in indices is the calculation of free float. Many indices either count equities that aren’t available on the market or under-represent a company’s available equity. Salomon Smith Barney launched its world equity style indices in Europe. These include the free float while excluding the likes of corporate cross holdings, private holdings over 10%, government holdings and legally restricted shares.
Thomas Nadbielny, managing director at Salomon Smith Barney in New York, says gross distortions exist in the European markets, particularly the telecoms sector where companies like Deutsche Telecom have a free float of 35% but a weighting of 100%. As a result the stock is chased and the price distorted. On the flip side there are some companies being either left out or under-represented in indices and this is another source of what SSSB calls benchmark risk. As an example, Nadbielny compares two indices with a near-prefect correlation of 0.995 but a 9.4% difference in returns in the five years to December 1999.
Both Nadbielny and Ian Toner, his colleague, are passionate in their convictions, as anyone who has witnessed their presentations will testify. The argument is taking hold. FTSE has embraced free-float weighting within what it calls a band approach aimed at curbing excessive adjustments. Anything with a free float of between 25% and 50% automatically qualifies for a weighting of 50%. MSCI makes no account for free float but says it is considering it. Bridgeland says what’s more important is that the pension funds understand what definition of free float is being used in an index. Specifying free float is hardly an exact science anyway. For example, how do you classify stocks bought and held by index trackers?
The introduction of the euro has produced a pile of new indices to differentiate between Euroland and what was once plain Europe. The merger of the London and Frankfurt exchanges and the raft of alliances and mergers among European exchanges will create even more. FTSE has launched Norex 30, a tradable index, in conjunction with the Norex alliance and other indices in conjunction with the Athens and Madrid exchanges. Its Eurotop 100 has had a makeover recently and MSCI has launched both narrow and broad indices for the Euro-zone.
There’s also been an increase in the number of narrow, specific indices, particularly in the TMT sectors. Banks like CSFB and HSBC are also producing indices for clients. With the move from balanced managers to passive core management, there’s ample demand for more indices and Bacon & Woodrow’s Bridgeland says there won’t be a shortage of new contenders. Once you get into currency and currency hedging you need to separate Euroland from other European currencies. Then there’s the question of EU expansion, membership of the euro and when and if Britain joins up.
Whether it will is anyone’s guess but in what is now such a crowded market, many of the new indices will be short-lived. “There are some that will fall by the wayside but that’s more on the tradable side where sometimes you try to catch an investment trend that lasts for a while and then disappears,” says FTSE’s Keith. IPE