Are Equity Indices Becoming More Alike?

Research carried out by Norges Bank has found two of the best known global equity benchmarks are converging in terms of risks and rewards.

(January 29, 2014) — Performance of MSCI and FTSE global equity indices has converged since 2001, despite each claiming to their investors to have fundamental differences.

Norges Bank Investment Management (NBIM) has undertaken analysis of the MSCI GIMI and the FTSE GEIS indices to see if there were any differences in risk/reward performance, and found that the two indices have been steadily converging since 2001.

From a return and risk perspective, the analysis indicated that over the past 10 years FTSE had a higher cumulative return than MSCI, but most of that outperformance occurred between 1998 and 2001.

After 2001, performance of the two indices has converged. In terms of index composition, the two indices historically overlapped each other with around 93%-94%, of their stock selection, but this increased to 96% after FTSE’s change of free-float methodology, NBIM said.

There remain differences between the two indices, however. While both follow broadly the same set of classification rules, there are anomalies, such as how they classify South Korea (FTSE: developed, MSCI: emerging).

FTSE includes index orphans— stocks that are not often tracked by analysts due to being not very well known or because it belongs to an industry that is generally performing poorly—which allows FTSE to gain from companies with an ambiguous country-classification, while MSCI’s decision to target 99% of the investable universe, compared to FTSE’s 98%, means they have different medium-sized company definitions.

But these differences amount to almost nothing in terms of performance, NBIM found. It said the trend for benchmarks to be created from concentrated portfolios covering a specific set of markets and the development of “best practice” for constructing market-cap-weighted indices had resulted in returns being almost identical.

The convergence may also be driven by the needs of the fast-growing ETF sector, NBIM’s report said.

“For an index fund or an ETF vehicle, where replicating a benchmark is the goal, availability of liquidity (which the vendors try to ensure through relatively complex liquidity rules and narrow free-float bands) at every point in time is of high importance,” the report continued.

This convergence is leading investors to find other differentiators, such as cost, instead, NBIM concluded. Based on a simple indicator of trading, NBIMA found that less trading was required to follow MSCI historically, cutting costs for investors. But this was unlikely to continue in future, thanks to FTSE’s change in free-float methodology in March 2013.

Leaving cost considerations aside, a potential differentiator in the future might be increased transparency in areas of benchmark construction.

Index transparency is currently difficult and costly for investors to verify. In particular, free-float adjustments can put asset managers in a worse position to understand how the final benchmark is constructed and how the weight of each constituent is assigned, NBIM argued, due to the lack of clarity on the information used for the adjustments.

The full discussion paper can be found here.

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