For two years leading investment index vendors FTSE and Morgan Stanley Capital International (MSCI) have laid the groundwork to bring their products up to date, in the process creating unprecedented trading requirements for investors and potential opportunities for hedge fund managers. Over the course of the next month those changes will finally begin to take place, prompting analysts once more to forecast the anticipated action in the market.
In the case of MSCI alone, says Benjamin Bowler, director of equity derivatives strategy at Merrill Lynch in Tokyo, passive investors will be required to conduct $100 billion of equities trades involving thousands of securities. On top of that, more investors who reference the MSCI indices, even if they don’t follow them note for note, will also be forced to trade as a result of index changes.
Tim Kay, principal and head of Asia Pacific and Japan at MSCI, estimates $3-4 trillion of assets reference MSCI indices, and up to $500 billion of assets managed by passive investors track them directly.
“It’s rare to meet any investor without a benchmark,” says Bowler. “This is going to be the largest change to indices in the world.”
On 19 May, MSCI will announce its long-awaited changes to company market capitalizations, as well as additions and deletions to all its global indices, as a result of its move to account for free floats – the proportion of share capital deemed available for purchase in the public equity markets by international investors. By refusing to count shares held by governments, owners, insiders and cross-shareholdings, the changes are bound to impact Asia and Japan far more heavily than any other region of the globe. MSCI is also adding stocks to its indices to capture 85% rather than 60% of each industry group.
FTSE announced in 1999 that it would do the same, and its changes are due in a ‘Big Bang’ on 15 June. MSCI, which enjoys an approximate 85% of market share as an index vendor, has decided to phase in its changes over one year starting 31 May, and in the meantime will run two parallel indices, allowing investors to choose when and whether to switch to the new product set, says Kay.
This gradual strategy is likely to thwart hedge funds and prop desks looking to make a killing. MSCI learned how not to reweight its indices last April when Japan’s Nikkei 225 changed 30 stocks on one day. In the run-up, traders shorted those stocks that were to be kicked out and went long the new constituents, and made what could be the biggest one-day profits ever. Many American and Japanese firms threw their balance sheet at it and made $100 million or more, each (see FinanceAsia magazine, October 2000).
This time in MSCI’s case, investors have a year, although Nizam Hamid, director of portfolio trading and index research at Deutsche Bank Securities, believes most will try to make changes as soon as possible.
As a result, analysts predict that the FTSE and MSCI changes will not create similar distortions. By slowing down the process, MSCI allows fund managers time to gather liquidity. And while up to 30% of the MSCI World universe of stocks is expected to turn over, the impact to performance should be minimal, analysts say. Bowler notes overall turnover may not actually rise so much this year compared to last year, because of high M&A activity in 2000 and 2001.
Hamid says: “Post-free float, investors will find very little to differentiate the main benchmark indices.” There will, however, be major shifts among sectors. At a trading level, Hamid believes most investors will try to avoid the main change dates of November 2001 for FTSE and end May 2002 for MSCI. They will be able to use program trading and country futures to avoid impacting the markets. Surprises could come, however, if market players guess wrongly what kind of changes MSCI will announce on the 19th.
Japan, with its legacy of cross-shareholdings, has been singled out as most likely to experience a gradual capital flight to markets with greater free floats – some estimates by analysts put it at a $7 billion loss. But Bowler says so many investors are underweight MSCI’s Kokusai Index that the impact will be soft.
