Now You See It, Now You Don't - iShares Make the Move to MSCI Provisional Indexes By John Spence and Jim Wiandt July 31, 2001

Barclays Global Investors (BGI) is doing its best to help investors manage the MSCI switch to float-adjusted indexes, and on Friday it announced it is ahead of schedule. BGI says all 21 of its MSCI-based iShares exchange-traded funds (ETFs) have been rebalanced to reflect the new indexes. Last month BGI said it would complete the iShares rebalancing by the end of August, but apparently the iShares managers haven't been taking it too easy this summer.

No doubt the words "free float" have become ingrained in the minds of many passive investors this year. In December 2000, index provider MSCI officially announced that it would adjust all of its equity indexes for free float, and that it would expand market representation from 60% to 85% coverage. On May 19 of this year, MSCI released the constituents for the adjusted indexes, which it called its new "provisional" indexes.

MSCI estimates that over $3 trillion is benchmarked to its indexes, with about $500 billion directly indexed. To cushion the impact of the switch, MSCI is enacting the transition in two stages over a one-year period, with the indexes becoming fully rebalanced on May 31, 2002. However, investors don't have to wait that long to make the switch to the provisional indexes - they now have low-cost options in the rebalanced iShares.

So far, the impact of the MSCI switch on international stock prices appears to have been overplayed by many financial analysts. Since it became apparent last year that MSCI was contemplating the shift to float-adjusted indexes with broader coverage, speculative traders have been making bets in anticipation of the index overhaul. Essentially, their strategy was to front-run indexers by buying up stocks that were to be added to the index or experience greater weighting as a result of the switch. But that strategy hasn't worked out so far.

Why? Time is one reason. Passive managers have a whole year to rebalance, which gives them trading flexibility and the freedom not to be forced into huge block trades. And with such a long time frame, other fundamental market forces are likely to overwhelm any "index effect" that artificially influences stock prices.

"We are in the driver's seat because we literally control the gas pedal," says Steven Schoenfeld, managing director of BGI's international equity management group. "We don't have to reward front-runners because we have time on our side. If the spreads are too big, we simply ease off the gas pedal or shift to another gear."

According to BGI, companies that have been added or whose weight is being increased in the MSCI EAFE and Emerging Market indexes are underperforming stocks which are being deleted or having their weight decreased since MSCI announced the provisional index constituents on May 19.

"Index Effect?"
EAFE adds vs. deletes
cap-weighted	-3.4%
equal-weighted	-2.1%
Emerging Markets adds vs. deletes
cap-weighted	-6.7%
equal-weighted	-3.7%
EAFE adds vs. deletes adjusted
cap-weighted	-3.4%
equal-weighted	-3.1%

Source: Barclays Global Investors, performance since 5/19/01, as of 7/20/01

A few words on the above chart. "Adds" and "deletes" refer to the 50 securities (100 total) with the largest weight increases or decreases. And to better quantify "index effect," BGI calculated a EAFE adds vs. deletes adjusted, which attempts to strip out country and sector effects within the changes.

The reason for most of this outperformance is simple, and was overlooked or underemphasized by many analysts.

When you rebalance holdings, you are making implicit bets on certain equities and markets. With the new provisional MSCI EAFE, for example, you are making a net bet against Japan, which will have its representation decrease in the float-adjusted indexes, and a net wager for the UK market, which will see its weight increase.

But who knows what the market will do? All things being equal, one should make a switch to the new indexes as soon as possible to avoid the squeeze effect of all those indexers buying the additions and selling the deletions. Even this effect is not so simple. According to BGI, even when returns are adjusted for market and currency effects, the provisional EAFE adds trail the deletes by 3.4%, on a cap-weighted basis. This means that the effect of all that hedge fund activity has actually caused the provisional EAFE to underperform the standard EAFE since components were first announced May 19.

"The more you spread out the transition, the more risk is pushed over to those who would front-run the indexes," said Binu George, principal and global equity strategist at BGI . "The multitude of market factors are an iceberg below the surface that will often work to torpedo the trade."

While one may argue about the ability to isolate cause and effect in equity pricing, one cannot argue with the raw performance numbers. That data clearly underscores the fact that the market includes a multitude of factors playing out and providing plenty of cover for fund managers to negotiate, given time, any index effect.