Every day, MSCI calculates and publishes about 150,000 equity market indices around the world. Its flagship index, the All Countries World Index (ACWI) tracks equity markets in 46 separate countries.
Such is the appetite of investors for benchmarks to help them track and measure investment performance and to implement cost-effective asset allocation models that MSCI’s managing director and head of index, Asia Pacific, Theodore Niggli, says he can foresee a day when MSCI publishes a million individual indices. Every day.
To complicate things, indices are not static. They are dynamic, changing, living things. They are constantly adjusted, tweaked and recalculated to reflect a range of issues, including corporate actions such as share buybacks or new issues. If a company with foreign ownership restrictions hits its limit, it may be removed from an index because it is no longer investable. If a company’s share price falls it may be dropped from a capitalisation-weighted index. And of course, new listings have to be added in.
Niggli says understanding how an index is constructed – not just its constituents, but the governance, methodology, transparency, innovation and consultation by the index provider – is critical when it comes to choosing an exchange-traded fund (ETF) or other index-tracking product.
“Governance is around, how is the index managed every day?” he says. “How is the methodology set? Typically you look for things like the index provider giving you a policy on how a decision is made. In the case of MSCI, the index policy committee decides. We use market consultation to get a view, but at the end MSCI decides.
“One thing that’s very sensitive for an index provider is when you add in or remove securities from an index, you don’t want to surprise the market. We pre-announce all our moves.”
Totally transparent
Niggli says MSCI’s index-construction methodology is “totally transparent”.
“It’s published, but it’s complicated,” he says. “If you read through it, everything is in it. There are a lot of different things we have to factor in, but it’s totally transparent. That’s what you want to see – how reflective it is of market evolution.”
Niggli says the quality of the data used to build an index is also critical. MSCI uses about 80 data vendors, and for every data point it has at least three independent sources.
“That data quality is very important, especially in today’s world where things move all the time,” he says. “We publish data every day. What MSCI wants is that anyone who reads our methodology carefully is able to replicate our index – they know exactly what we’re going to do, ahead of time.”
Niggli says most index providers are innovative, and he says innovation should come from “understanding the investment process”. An example of this is how environmental, social and governance (ESG) issues can be factored into an investment portfolio.
“You want your index provider to innovate on things that are important to you as an investor,” Niggli says.
Index providers license the use of their indices to the issuers of ETFs, so in some cases there is vetting of an issuer or a product to ensure the index and the name of the provider are not being misused or misrepresented.
“We don’t second guess whether Vanguard or iShares or State Street can run an ETF,” Niggli says. “But in the beginning we did ask. We also spend time on the name of the fund, so there’s no misunderstanding of what this ETF is – they can’t call it the ‘All The Stocks Will
Go Up Index’.”
Assess the investment case
If an ETF issuer brings an idea to an index provider and asks them to construct a bespoke index, Niggli says the index provider should first assess the investment case for the index idea. There may be a limit to how finely equity markets can be sliced and diced to create new indices, but that limit is some way off being reached.
“We calculate 150,000 indexes a day and there’s only 15,000 investable stocks, roughly,” he says. “We believe that one day we’ll be calculating a million indexes.”
He says indices were originally developed to help institutional fund managers with performance attribution. Then they evolved to help investors quickly and easily identify stocks with similar characteristics, such as being in the same industry, or identifying those in emerging and frontier markets.
“The advent of factor [indexes] is just another dimension of that, these smart betas; to say, based on academic literature there are certain behaviours, a consistent mispricing or an error, or a long-term premia if you buy those kinds of stocks,” Niggli says.
“So we codify that and say if you want to look at what the value premium looks like…here are two or three ways you can define value, and here’s the historical performance of that portfolio.”
