Equity Index Guide

EuroBusiness Media (EBM): iShares has just published its new Equity Index Guide. EBM: You are Managing Director, ETF Strategy at iShares. First, to give us some context, what are some of the noteworthy recent evolutions in the world of equity benchmarks? NH: I think the key thing that we've seen in the European benchmark landscape is a convergence of the main index providers. They've all moved to a very similar methodology looking at the whole of Europe as a single entity, looking at large, mid and small cap stocks. And effectively what we've seen and what we talked about to investors in the guide is that someone using a STOXX 600 ETF or an MSCI Europe ETF, or if they have FTSE as a benchmark, would now have a product that very much trades in a very similar way and where tracking errors are very low and correlations are very high. So anyone can really use these broad benchmark products because all the indices have very much converged in terms of their methodology and ultimately the asset class they're trying to represent. EBM: What are the key things for an investor to keep in mind when looking at an index, since after all not indices are constructed the same way? NH: I think it's very important for investors to look at what's happening underneath the index, to examine what's going on with the constituents, the index rules for different exposures. And that transparency of an index normally follows through to the transparency of the ETF that they're likely to trade. But they also need to understand what they're tracking. Is it a price index? Does it reinvest the dividends? How does it treat certain corporate actions? How do they measure their returns correctly? So there are a lot of different nuances that need to be taken into account and those are the sorts of things that we cover in the Index Guide, to really help explain to investors the difference between a local index, the price, net total return, gross total return, all those different factors which are very important to understand your exposures. EBM: Could you quickly give us some examples of what you mean when we're talking about different types of index construction? NH: Probably if you look at some of the most famous indices in the world, you've got the Dow Jones Industrial in the US, you've got the CAC 40 in France. The Dow Jones is a price weighted index, so the weight of any stock in that index is simply designed by its price, so the highest price stock has the highest weight. It doesn't need to be the largest market cap. If you look at the CAC 40 you have an index which is free float adjusted and has the market cap adjusted for the value of those companies. It clearly gives you a better representation of clients' ultimate portfolios and the exposures they're likely to have, whereas the Dow Jones is a great headline index that is not used as a benchmark for many investors even in the US or in any part of the world. EBM: Surprisingly perhaps, an ETF's tracking error against the index is never equal to zero, meaning that it doesn't match up perfectly. Why is that? What are some of the factors to take into account to explain the differences? Is it solely due to commissions or fees? NH: No, I think one of the key things for investors to remember is that an index is a theoretical example of the calculation of the performance of a group of assets. And there are a number of factors that it doesn't take into account. So when a company pays a dividend, the index provider will assume the dividend is received immediately by the index fund. But in the case of UK dividends you might need to wait over a month before you actually receive those dividends to reinvest them into the actual fund. So you can't really replicate exact matters. When you have corporate actions, be it a rights issue or a takeover, the index treatment will be different from the treatment in the real world and in the market. That creates tracking error. The different treatments of taxes within an index compared to the tax that you might receive within the fund, again, creates a tracking error. So there are very many operational issues where the ETF will physically own all the securities – potentially all the securities in the index you can hold physically – but you still won't match exactly what the index is doing because the index is that theoretical example of what's going on. It's not a real world example of managing a portfolio. EBM: Another thing to watch for would seem to be the definitions – large, mid or small caps – as these size definitions vary widely from one index provider to another. How do the criteria for size, investable universe and liquidity vary from one index provider to the next? NH: Perhaps the best example of that would be MSCI where they've broken down the index into large, mid and small cap. Large and mid, effectively, they built to create 85% coverage of the index, and small cap is the rest of the investable universe. Now you take STOXX. You have a STOXX 600 and they have large, mid and small. But if you take the small cap portion of the large index, that's all you're doing. You're not taking pure small cap stocks. You have exposure to the smallest 200 stocks out of what is ultimately a large cap index. That will not give you pure small cap exposure. So clearly the differences in the way MSCI treats small caps versus FTSE and STOXX will give you a very different exposure. And that's why it's important to understand: is a STOXX Small Cap Index for Europe the same as an MSCI Small Cap Index for Europe? And the answer is clearly no. EBM: Isn't there a grey area of definition also when it comes to developed or emerging country indices depending on whose definition you're looking at? NH: Certainly. MSCI and FTSE have different definitions for different countries. MSCI has developed market, emerging market and frontier markets. From an MSCI perspective, Israel will move to becoming a developed market in May 2010. For FTSE for example, it had already moved it from an advanced emerging to a developed market in August 2008. Korea is another good example. FTSE in September moved it from advanced emerging to developed, and MSCI have completely postponed that decision. So depending on which regional index you have exposure to those definitions will have a very important impact on the type of country exposure you have. And that's really something, again, investors need to take into account when understanding which regional exposure they want to have. Is it developed and emerging? Is it all country? How are they taking that into account and how much risk are they taking on board? EBM: Why is it that in some parts of the world, such as Asia, there can sometimes be a significant tracking error ranging from 3% to 4% between the benchmark for the ETF and the ETF itself? NH: What you have to remember is an ETF, especially ones that trade in Europe are designed to be liquid and are designed to give people access to those products. So Asian markets are typically quite hard to trade. You have currency cost risks, a lack of liquidity in some of the smaller stocks. So typically, for a physical ETF we'll build an ETF that maximizes the liquidity. We make it easier to trade in Europe. That might mean owning ADRs or GDRs, other types of instruments which represent the local stock. That gives you a very significant amount of tracking error. But what it also means is that over time – because the performance of the ADR and the GDR should match that local stock – it should iron out those differences. So you’ll get perhaps significant day to day changes, but over time the performance of the ETF should really match the performance of the main benchmark that it's aiming to track. EBM: In your Equity Index Guide, you did some interesting research showing that there can be some stark differences in Europe, for example between the local benchmark and the MSCI Country Index for the same country? What's going on here? NH: Different index providers have different rationales for including stocks in their indices. So if you're a provider of a local benchmark which would typically be the local stock exchange – the LSE in London would work with FTSE, the EuroNext would work to create the CAC and then indices for the AEX – your aim is to drive liquidity into stocks that are domestic and trade on your exchange. Those aims are slightly at odds with the aims of a major index provider with a global index family. So you get unusual examples of perhaps Royal Dutch Shell which is combined to be a single company being in the AEX, whereas, of course, it's actually now a UK PLC. So it wouldn't appear in MSCI's index. You have different capping strategies in different country indices which means that the weights of certain stocks will be capped in some local indices and not capped in the benchmark. So you would have a capping factor for some of the stocks in the CAC, for some of the stocks like Total, you would have a capping factor for stocks, say, in the DAX. You wouldn't have the same impact in the benchmarks in MSCI. That leads to a very large difference in those indices. EBM: Lastly, in addition to the Equity Index Guide we've just discussed, we noted that you've also just published a Fixed Income Index Guide. Wouldn't that be a lot more challenging given the absence of benchmarks in the fixed income world? NH: Certainly, it's challenging. We've covered about seven different index providers in that guide and they all have slightly different twists on the methodology they use, different sources of pricing for the underlying bonds and different exchange rates, different criteria for the individual bonds. So yes, we found that a more challenging area for investors to focus on. And that's why we produced a guide focusing on fixed income, produced a guide also in French that helps people understand what's really happening in that part of the market. EBM: Nizam Hamid, Managing Director, ETF Strategy at iShares, thank you very much. NH: Thank you.