There are mainly two types of investing in today’s world – active investing and passive investing. Passive investing implies simply investing to earn returns equivalent to the overall market. A country’s market is typically represented by its benchmark index. For example, in the US, S&P 500 is a stock index that represents 500 of the country’s largest publicly traded companies.
The weights of the individual companies in this index are equivalent to their free-float market capitalization. That means the larger the value of the company’s freely available share, the larger its weight. This is a fairly accurate way of representing a country’s stock market. So, in passive investing, you intend to track the returns of this index.
In active investing, you try to invest such that your returns are higher than this benchmark index. The idea is not simply to gain positive returns but, in fact, invest such that the returns are higher than those of the index.
Issues with active investing
Every money manager, whether active or passive, would charge some fees for those returns. Since active investing requires a significant amount of work on the part of the manager, higher amounts of fees are charged if one wishes to invest in active funds.
However, several studies done on decades of performance of these funds have shown that, on average, active fund managers are barely able to beat the markets. In fact, if one takes into account the fees charged by the manager, active funds provide lower returns than the index. So, one would be better off simply investing in the index rather than these funds.
Index funds to the rescue
Now coming to passive investing, there was another problem. To track the returns of an index, for example, the S&P 500, one would need to buy all the 500 stocks in proportion to their respective weights. Now that is practically impossible for individual investors to implement.
This is where the concept of index funds comes in. Index funds take investments from a large number of individuals and then use them to build a portfolio capable of tracking the index.
John Bogle, the founder of Vanguard, is credited with creating the first-ever index fund and introducing a low-cost and convenient method of investing. Now, while there are individual country indices, many of these are not suitable for global investors. This is because many of the stocks have restrictions or limits on how much of the shares can be held by overseas investors.
In order to overcome this, firms like Morgan Stanley Capital International (MSCI) decided to create indices suitable for investors across the globe. These indices include not only country indices but also the ones tracking entire regions and country groupings such as the Asia Pacific index, Emerging Market index, and All-World index.
These funds have become widely popular for investors across the world. Currently, trillions of dollars are invested in funds that track the MSCI indices. Most of these funds are managed by Blackrock, which is one of the world’s largest investment management firms.
Just to give an example of the size of these funds, a couple of iShares funds tracking the MSCI Emerging Markets index hold more than $50 billion in assets under management. The fund tracking MSCI EAFE index, which tracks developed markets in Europe, Australasia, Israel, and the Far East, holds a whopping $100 billion in assets!
These indices obviously do not have the same set of stocks all the time. As mentioned above, the primary way to represent the market is in proportion to the free-float market capitalization. On top of that, in the case of overseas investors, foreign restrictions also need to be taken into account. MSCI, in its methodology documents, lays out a number of rules and parameters to decide on the weight of stocks and which stocks to be included.
MSCI quarterly and semi-annual reviews
On the basis of the above rules, MSCI updates its indices every quarter. The announcement of the changes happens early in the month, and the changes are typically effective from the last day of the month. The quarterly reviews, which are less comprehensive in nature, happen in February and August, while the semi-annual ones, which involve significant changes, happen in May and November every year. The changes announced include changes in weights and the inclusion or exclusion of stocks.
For a stock, the entry or exit into one of the MSCI indices is of huge significance. For example, let us assume that a stock A enters the MSCI emerging market index with a very small weight of 0.5%. But let us understand the number of flows that could potentially take place in the stock. With $50 billion tracking the index, even a 0.5% weight results in a $250 million inflow.
This impacts the stock in three different ways. Firstly MSCI implements the changes in the last 30 minutes of a trading session right before the effective rebalance date. This means a massive flow happens in a short period of time, significantly impacting the stock price.
Secondly, inclusion in an MSCI index is a big validation for the stock, so even the announcement of inclusion triggers a wave of positive sentiment for the stock leading to price appreciation.
Finally, even before the announcement, market participants try to predict which stocks will get included or excluded. So, depending on the probability of entering or exiting the index, these stocks start seeing a price increase or decrease respectively.
From backtests on several MSCI reviews, it has been observed the stocks that are included in the index tend to outperform the indices a few weeks before and after the inclusion. Similarly, stocks expected to be excluded underperform over the same period.
These reviews also involve changes in country weights in these indices. For example, China A-shares have seen inclusion and weight increases in the MSCI indices over the past few years. This has brought in a significant amount of inflows in the country and also supported the China equity market levels.