Asia gets mixed results in MSCI changes

Fund managers just want to get back to fundamentals.
The changes to the Morgan Stanley Capital International indices to account for free floats – the amount of a company’s shares freely available to any foreign portfolio investor – were announced on Saturday. Asia ex-Japan’s total market capitalization weighting in the MSCI World index has been cut by a third, from 3.38% to 2.89%. But individual countries in the region will be gainers – and others even greater losers, say Merrill Lynch co-heads of Asian derivatives research Ken Chang and Todd Kennedy.

But they add that in the long run, these flows are insignificant except at the company level. The entire MSCI process is so drawn out – the parameters of the changes were announced a year ago, and investors have now 12 months to implement them – that fund flows will not be impacted. Chang notes that all the trades in the region to accommodate investors to the MSCI changes probably add up only to several days’ trading volume.

The process is not over. The Merrill analysts say that while MSCI has done a good job, and noted the seemingly interminable process of changing indices is good for stability, the vendor has made some errors in determining free float amounts. For example, Chang says some H shares were inexplicably deemed to have a 100% free float.

In addition, Japanese banks have apparently gotten away very lightly. “We disagree with MSCI’s assessment of Japan having a 75% free float,” says Kennedy. “No one in the market thinks it's that high.” Merrill and other market players are collating opinions for MSCI, and they expect the vendor to tweak the changes at some point in the future.

Benjamin Bowler, Merrill’s Japan derivatives research head, had originally predicted a net outflow from Japan of $7 billion; in the event it is only going to be $3.7 billion – less than France (a loss of $5.1 billion), or Germany (out $4.3 billion).

For investors, this has been a major pain in the 'rear end', the analysts remark. While everyone welcomes the MSCI adoption of free-float requirements, this represents a massive technical adjustment that has nothing to do with the fundamentals of the underlying stocks.

For some global managers, says, Kennedy, “The lesser weight on Asia may be joy or it may be tears, depending on your outlook.” But for anyone tracking or benchmarking against MSCI indices (which according to MSCI involves $3-4 trillion worth of assets) must face trading and administration costs. “We have a year to go and we’re already feeling MSCI’d out,” Kennedy says.

Winners and losers

Within the Asia-Pacific context (including Australia but not Japan), Australia is a massive winner. Its current weight of 25.75% in the MSCI All Country Asia Pacific Free ex-Japan index has risen to 35.09%, mainly at the expense of South and Southeast Asia, according to Merrill Lynch.

Within the Asia ex-Japan universe itself, the biggest gainer is Korea, which Merrill Lynch calculates will benefit from a net inflow of $890 million, boosted by the addition of Samsung Electronics preference shares, as well as shares of others such as Korea Tel Freetel, thanks to the removal of cross-ownership with Korea Telecom.

China is also a gainer ($420 million), with the addition of several large-cap names such as Sinopec, but Taiwan a modest loser (-$108.85 million) and Hong Kong a major loser (-$1.1 billion). Taiwan’s fall is almost completely attributed to Taiwan Semiconductor Manufacturing Company’s reduction in MSCI Taiwan from 20.78% to 14.52%, as other, smaller names were added.

Hong Kong saw Cheung Kong return and MTR Corp added, but overall weight drops in Hutchison Whampoa, Hang Seng Bank, Sun Hung Kai Properties, Cathay Pacific and Johnson Electric have dragged the SAR’s position down.

Nonetheless the proportional change to Hong Kong in the MSCI AC Asia Pacific Free ex-Japan is small (almost -5%) compared to the true losers: India (-53%), Pakistan (-51%), Malaysia (-42%), Thailand (-42%), Philippines (-34%) and Indonesia (-28%).

A raft of what should be benchmark companies such as Thai Airways were deleted because of overwhelming family ownership levels; MSCI’s new policy is to exclude companies with less than a 15% free float.

Companies wishing to rebuild a presence in MSCI indices will have to release more shares to the public, says Kennedy.

The big winners were the United Kingdom, which Merrill calculates will receive $10.3 billion of funds, and the United States, which should benefit from a $8.1 billion inflow. But their capital markets are already so large, and the timing of the flows so spread out, that they are unlikely to notice.