MSCI Index Changes

How MSCI index changes affect investors

Stock market indexes exist for a few reasons. For pension funds, they serve as a “measuring stick” against which the plan’s performance is compared. Indexes can also be used to monitor an investment manager’s adherence to his/her stated strategy. Still, others invest with the sole objective of simply mimicking the performance of one or a combination of many stock indexes. Morgan Stanley Capital International (MSCI) is perhaps the dominant designer of overseas stock indexes. Last year, MSCI announced that they would be changing their methodology from “total market cap” to a “free float” approach to structuring indexes. Understanding what changes will occur will help assess the impact on investors and if any action is necessary.

Background of index construction

When constructing a stock index, the goal is to come up with a “basket” of stocks that is representative of the marketplace. Using Canada as an example, the S&P/TSE 60 stock index essentially consists of the sixty largest companies in the TSE 300 – like Nortel Networks, BCE, the big five banks, etc. Similarly, most MSCI indexes include the largest companies in various markets. For instance, the MSCI Europe Australia Far East (EAFE) index currently lists European firms BP Amoco and Vodafone, in addition to Toyota Motor Company and Nippon Telephone and Telegraph (NTT) of Japan. These companies, along with all others in the index receive different weights in the index, based on each stock’s “total market capitalization” – i.e. the total number of shares outstanding multiplied by the most recent market price of each share. However, not all of a company’s outstanding shares are available to be traded on public exchanges (“free float”) – hence the change in approach.

The change in index construction

Last December was the official announcement of the MSCI index construction change, which is to begin taking effect this year. In a nutshell, the current method of weighting companies by the total value of their shares ignores the fact that many company insiders and governments own significant chunks of many large companies. For instance, the NTT Law requires the Japanese government to own at least one-third of the total outstanding shares of Nippon Telephone and Telegraph (NTT). That means the government-held shares are not traded on Japan’s Nikkei Stock Exchange, effectively taking those shares out of the “public float”. The change to a free-floating system, then, refers to weighting each company in each respective MSCI index based on their “free float” or the total value of shares actually available on public exchanges.

Continuing with our NTT example, MSCI will cut the firm’s index weighting by eighty percent – implying that only one-fifth of NTT’s total shares are in the “free float” of the public markets. This is one of the more extreme examples but it becomes clear what some investors will be facing over the next year.

Investor impact

First, let’s review a couple of quick definitions. There are funds known as “index funds” that have a specific goal of tracking the performance of established stock market indexes – such as those designed by MSCI. That approach is known as “indexing” or “passive investing” since there are no decisions made by the fund manager. Most mutual funds, however, have a manager (or team thereof) with a goal of picking good stocks that can outperform the market indexes. Since they are active in the selection of stocks, this approach is known as “active management”.

Since actively managed funds simply try to pick good stocks, they won’t really care if the index weights are changing – resulting in no real impact. Hence, index fund investors will be most affected since most foreign index funds are based on the MSCI indexes. In order to track the adjustments made by MSCI, index fund managers will have to do a lot of buying and selling to re-adjust the weights of each stock to match the new methodology.

If you’ve been reading my columns for any length of time, you’ve become familiar with the term portfolio turnover. It refers to trading frequency and it has two potentially damaging side effects for investors – trading costs and income taxes. The truly significant impact on investors in this case will likely be income taxes. Think about it for a minute. Let’s say you’ve held shares of a company for many years but haven’t paid tax on the growth since you’ve never sold any of your shares. If, after several years, you decide to sell off eighty percent of your stake, you will trigger a significant capital gain – resulting in a potentially large tax bill come next April. This is the danger for index investors.

Barclays Global Investors, one of the world’s largest index fund managers, estimates that the buying and selling needed to adjust to this new methodology will result in nearly one-third of the value of EAFE index funds being traded. With an estimated $3 trillion US tied to MSCI indexes worldwide, there is a massive amount of stock trading waiting to happen as a result of this change. That means a lot of potential tax bills waiting to happen for index fund investors. The problem, of course, is that selling in an attempt to avoid the impact of these changes could result in an even larger tax bill than if you stay put. MSCI is implementing the changes in two steps – in November 2001 and May 2002. Is there any place to hide from this massive trading that awaits index investors?

Recommendation

Since most international index funds available in Canada have only been around for four years or less, you may not need to take any action since overseas markets have not had great returns over that time. (Canadian and US index funds have been around for nearly twenty years, but no funds in either category follow any index designed by MSCI.) For instance, the TD International Index fund is the oldest Canadian fund tracking the MSCI EAFE index but it was launched in 1997. Its top fourteen holdings add up to nearly a quarter of the entire portfolio. Based on year-end cost and market values, and the planned adjustments by MSCI, the top holdings should see turnover of about 12 to 15 per cent with minimal tax implications. It’s important to note those numbers are only relevant one-quarter or so of the fund. The estimated turnover for the entire fund is about twice that estimated for the top holdings but tax consequences may not be very severe. To judge the full impact, the entire portfolios of each fund would have to be examined – something I’ve not done.

Here is a guide on what you can do:

Ÿ Look through your portfolio to determine if you hold index funds.

Ÿ Verify which indexes your funds track. For those funds not tracking some MSCI index, the changes discussed here will have no impact. If one or more of your funds do track a MSCI index, some changes may be necessary.

Ÿ Determine the gain that has built up on those index funds tracking MSCI indexes. If it’s less than ten per cent, it may not be worth taking any action.

Ÿ Check with the companies whose funds you hold to get updates on distributions starting in mid-November.

This should help you decide on the course of action that is best suited for you. My suspicion is that most investors won’t need to do anything, but of course that could change based on market activity for the remainder of this year and next. And, of course, always get qualified advice before taking any action.

Dan Hallett, B.Comm., CFP is Senior Investment Analyst with Sterling Mutuals Inc. He can be reached at dhallett@sterlingmutuals.com Sterling Mutuals Inc. is registered as a mutual fund dealer in Ontario, British Columbia, and Manitoba.