Capital Group questions how indices are used; Mismeasurement of performance worries originator of MSCI

November 11, 2013 12:01 am

Capital Group questions how indices are used

By James Mackintosh

Mismeasurement of performance worries originator of MSCI

The rise of the multinational has transformed the corporate landscape in the past half-century. Now, the inventor of the most widely-used global stock market indices thinks the measurement of equity performance needs to change too – and with it the dynamics of investing. Capital Group – which, as Capital International, was the originator of the MSCI index range – is concerned that the standard national, or even regional, benchmarks used by fund managers no longer measure what they set out to measure. This problem has been evident in the FTSE 100 index for a decade or more, as less than a quarter of the revenues of companies in the Footsie come from the UK, and many of their dividends are paid in dollars or euros.But London’s best-known index is a bit of a special case, and not much money tracks it. Capital’s concern is that apparently more sensible and broader measures – such as the S&P 500, Euro Stoxx 600 or the MSCI country and regional indices – are also suffering significantly from mismeasurement.

“The world has changed but the industry hasn’t really kept up with it,” says Rob Lovelace, a director and portfolio manager at Capital, and grandson of its founder. “People don’t really know what they own in their portfolio or the risk that they’re taking.”

As befits a group that has used the same research-driven approach since it was founded in the Great Depression, Capital is not rushing to make changes. Initially, it plans to give customers a breakdown of their portfolios by location of revenue, as well as by location of listing or domicile.

However, Capital is right to question the indices used both as benchmarks for active fund managers (Capital runs the largest active mutual fund in the US) and as investments in their own right by passive groups. The Footsie may seem particularly egregious with its Kazakh and South African miners, but consider these anomalies:

● A third of the revenues for constituents of the broadest MSCI All-Country World index come from emerging markets, while only around a tenth of the index is made up of emerging market-based companies, by market value.

● Only one-fifth of the revenues of France’s Cac-40 and a little more of Germany’s Dax are local. Both have more revenues from emerging markets than they do locally.

● Even for the S&P 500, only about two-thirds of revenues come from the US.

Yet almost all investors still divvy up their equity portfolios according to where companies are based, with a heavy bias towards their home countries. Can this be justified?

There are a couple of reasons why it might make sense. First, corporate governance. This is set by the local stock exchange and local law, with additional limits set by index compilers. Investors buying British companies know they cannot be diluted without permission, and that takeovers will be properly policed. US corporate governance is more reliant on litigation, but far more shareholder-friendly than in continental Europe or Japan, let alone the wilds of emerging markets.

While picking only stocks listed in London or New York may be limiting, it at least provides some reassurance that shareholder interests are represented.

Second, convenience. It is easier to get to know a company based in the same country, whether for language, timezone or travel reasons. Instead, investors typically focus on the economy or region they want to hold, often based on the (dodgy) belief that faster economic growth will lead to higher returns to shareholders.

Currency risk is also treated as important, even though currency risk merely reappears through the company’s revenue line, instead of in the denomination of the shares.

But investors cannot ignore the existing system. Indices are so important to asset allocation that they have become self-fulfilling – as was demonstrated by the wholesale dumping of emerging market equities earlier this year. It took much longer for the shares of western companies with emerging market exposure to be hit.

Revenue-based indices offer the potential for better regional benchmarks. But they present their own problems, too. Truly global brands such as Coca-Cola would have a weighting in all regional indices, for example. Index weightings would also change more quickly than at present, as sales patterns shifted.

Still, it is a step forward for investors to know where their portfolios’ revenues come from. They need to stop kidding themselves that an allocation to a country or regional index gives them exposure solely – or even mainly – to those places.