Indexers dispute costs of switching benchmarks

Morgan Stanley Capital International’s foreign indexes would be cheaper for passive investors as they switch to free-float weightings compared to broader international benchmarks, according to a new study by Barclays Global Investors.

But competing indexers question the validity of BGI’s comparisons.

In a new report, San Francisco-based BGI says the cheapest options facing investors is to stick with MSCI’s Europe Australasia Far East Index or All Country World Index as the benchmark for their international portfolios.

Sticking with EAFE during the changeover will cost investors 0.29%, whereas sticking with the ACWI, which includes emerging markets and Canada, will cost 0.38%, according to the study.

In contrast, switching to the FTSE World ex U.S. Index from EAFE would cost 0.35%, while switching from ACWI would cost 0.44%. Switching to the Salomon Smith Barney Broad Market Index from EAFE would cost 0.47% and from ACWI, 0.58%, the study says.

Worldwide, BGI manages more than $150 billion in passive international assets, more than $75 billion of which is tied to MSCI indexes.

Say comparison faulty

Officials at Salomon Smith Barney are among those who believe that BGI’s comparison is faulty.

A switch from EAFE to Salomon Smith Barney’s Primary Market Index, “the true yardstick by which the cost of changing should be judged,” would cost just 15 basis points, says Tom Nadbielny, head of global indexes at the New York firm.

The Primary Market Index includes 648 companies representing the top 80% of the market capitalization of each country in the index, Mr. Nadbielny says. Average market capitalization is $10.9 billion. In comparison, EAFE includes 918 companies, which have an average market capitalization of $9.8 billion.

The SSB Broad Market Index, on the other hand, covers 3,800 companies and comprises every company in the world with a market capitalization of at least $100 million.

The ACWI should be compared with the PMI Global ex U.S. Index, Mr. Nadbielny says.

While MSCI has announced changes in its benchmark indexes to consider only the portions of a company’s stock that are available to investors – or their free float – and to offer 85% market coverage of the countries in the indexes, it will not announce the specific stock changes until June. The changes will be implemented in two phases in November and June 2002.

Steven Schoenfeld, managing director and head of international equity management at BGI and one of the authors of the study, says the company used the SSB Broad Market Index in its calculations because “that is the one that our clients have said they would want to switch to if they were to change benchmarks.”

Not necessarily expensive

But switching to the Primary Market Index from EAFE more than a year ago cost one retirement system just 0.02%.

The Virginia Retirement System in Richmond changed to the SSB Primary Market Index from EAFE as its benchmark for its $1.8 billion passive international portfolio.

Safa Muhtaseb, head of international investing for the $41 billion pension fund, says that officials were prepared for the benchmark switch to cost 0.125% to 0.25%.

But the fund’s purchasing of futures on companies in countries underweighted in the EAFE benchmark relative to the Primary Market Index and shorting of futures on companies in countries that were overweighted in EAFE relative to the PMI paid off.

“Our long futures outperformed the EAFE benchmark, and our short futures underperformed EAFE,” says Mr. Muhtaseb, so the fund made money on both ends of its trades, thus bringing the cost of the transition down to 0.02%.

“We got lucky,” he says. “The trades could have gone the other way.”

But in the view of Jane Staunton, director of marketing at FTSE Americas Inc. in New York, “Transition costs are only one issue.”

Nobody really knows what companies or countries will be going into the new EAFE index and what methodology will be used, she says. “If you didn’t know how they got to 60%, do you know how they’ll get to 85%?” she asks, pointing out that MSCI has been secretive about the methods through which it designs its benchmarks.

FTSE, meanwhile, began converting its benchmarks to a free-float weighting last year and will complete the conversion by June.

In its report, BGI says, “While many of the specific elements of MSCI’s index changes remain unknown, we can estimate the turnover due to expansion of capitalization range and adjustment for free float based on their current high-level proposal. The extensive pre-announcement period and phase-in approach will help to minimize market impact and the transition costs associated with MSCI’s index restructuring.”

But one industry source questions the numbers in the BGI report, given that no formal announcement has yet been made by MSCI, and notes that representatives from BGI, as well as other money managers, are on the MSCI advisory committee.

“Don’t you think it looks a little fishy?” he asks. “Just being at the meetings and seeing what comes up gives these people privileged information. They know earlier than everyone else what is going to happen.”

“That is an incredibly blatant falsehood,” says BGI’s Mr. Schoenfeld. He adds that the MSCI editorial advisory board, on which representatives from BGI and other money management organizations sit, is just an advisory board and “has no influence in policymaking decisions.”

Mr. Schoenfeld says that MSCI has an internal index committee that makes all decisions regarding changes in the index and that no one from any money management firm has access to the information before it is announced publicly.

In a report titled “Why Wait?” SSB makes a case for switching to its Primary Market Index now and not waiting for the changes in MSCI and FTSE to be implemented.

“The urgent question for owners and fiduciaries of capital is: `Why wait?’ If float weighting is a good idea in 18 months, why is it not a good idea today?” the report asks.

“As the conversion dates approach, trading liquidity in MSCI and FTSE indexes likely will dry up and natural crossing opportunities will diminish as investors hold back from committing new funds to avoid unnecessary turnover.”

The delayed implementation schedule camouflages, but does not reduce, the inherent costs of the transition to float weighting. “Under current circumstances, the sooner that managers of assets act, the more asset owners stand to gain,” says the SSB report. “The transition to float weighting would have been substantially cheaper six months ago and, in our opinion, becomes incrementally more expensive every day.”

says Gradual is better

BGI’s Mr. Schoenfeld points out that “99% of [international] assets are benchmarked to either MSCI or FTSE. We believe it’s better to change gradually.”

And the BGI report states that plan sponsors concerned about the potential performance impact and/or high costs associated with the changes may want to choose another benchmark index. Large index and quantitative money managers will provide “transition services, both for movements within their own fund complex or on a stand-alone basis. Access to this pool of liquidity can dramatically reduce the costs of a benchmark transition,” the report states.