By Abhishek Gupta, Executive Director; Pavlo Taranenko, Executive Director; and Sebastien Lieblich, Managing Director, MSCI Research.
Index rebalancing during high volatility: A balancing act
The coronavirus pandemic has caused significant volatility in equity markets. Developed markets, represented by the MSCI World Index, and emerging markets, represented by the MSCI Emerging Markets Index, both suffered declines of 34% year-to-date (as of May 12, 2020).
While equity markets have partially recovered from lows earlier in the year, the impact of the pandemic across the underlying universe of securities has varied – there have been changes to company market capitalization and stock liquidity, among other company attributes.
While we believe these changes warrant proceeding with our scheduled refresh of equity indexes so they best reflect the current opportunity set, some investors may be wary of higher index turnover during a relatively volatile market and the impact they may have on trading costs and index replication.
Seeking balance
The MSCI GIMI methodology aims to find a balance within necessary trade-offs across our market-capitalization-weighted equity indexes to meet multiple objectives. Apart from aiming to provide indexes that are precise, investable, and replicable, it strives to meet two other key aims:
- Timely reconstitution of securities to reflect the evolution of equity markets
- Limit index turnover to better support index stability and trading cost-efficiency
May 2020 GIMI index review
In accordance with the methodology, the MSCI GIMI Indexes will be rebalanced on the last business day of May 2020, with changes effective June 1, 2020. The proforma results of the rebalancing were announced on May 12, 2020.
As with previous May semi-annual index reviews (SAIRs), the May 2020 review involved reassessing companies against liquidity criteria, assigning companies to large-, mid- and small-cap size segments, and applying buffer zones to reduce index turnover. Though this SAIR was scheduled, with large shifts in equity markets, the need to refresh the index in this way becomes more pressing.
Assessing the investable universe
The May 2020 index review will result in the timely removal of securities that do not meet the minimum liquidity threshold and help ensure the rebalanced index meets minimum liquidity requirements. Additionally, rebalancing will allow the addition of newly eligible securities, including IPOs since the November SAIR.
Assigning companies to large-, mid- and small-cap size segments
The MSCI GIMI methodology assigns companies to large-, mid- and small-cap segments by determining minimum size-segment cutoffs that target market-cap coverage of 70% for large-caps indexes, 85% for standard indexes (large- and mid-cap) and 99% for IMI (large-, mid- and small-cap) in each market.
Typically, when based on stock price performance alone, companies can migrate from one size segment to another, leading to index turnover. However, when equity markets move, the minimum size-segment cutoffs in the MSCI GIMI are designed to adjust as they continue to target the same market cap coverage. This provides a natural buffer for the retention of companies within the same size-segment, which can reduce turnover.
In the exhibit below we show the performance of select key developed- and emerging-market countries as well as the change in the minimum size-segment cutoffs across these countries. The size-segment cutoffs adjusted with the performance of the underlying markets. Interestingly, for Chinese equity markets, which fully recovered over the period of analysis, the minimum size-segment cutoff adjusted upward, and in Brazil, where markets were severely impacted, the downward adjustment of the minimum size segment was significantly higher than other markets.
Equity market performance and changes in minimum size-segment cutoffs
Source: MSCI.
Source: MSCI.
Applying buffers to limit turnover
In an effort to control index turnover, the MSCI GIMI methodology explicitly applies multiple buffers that restrict inclusion, exclusion, and migration of securities between size segments. For instance, a security may remain in its current size segment provided its full market capitalization falls within a buffer zone set below the minimum cutoff. To illustrate, the exhibit below reviews the impact this buffer had on turnover for the same select developed- and emerging-market countries.
Impact of size-segment buffer
Source: MSCI.
To put May 2020 index turnover in context, the exhibit below shows it was in line with past May SAIRs. The 12-year period includes more benign market environments as well as volatile times such as the 2008 global financial crisis. Relative market volatility had no significant impact on index-rebalancing turnover.
May 2020 turnover was in line with historical averages
Source: MSCI.
Alignment between parent and derived indexes
The market-capitalization-weighted MSCI Global Investable Markets Indexes are also the underlying security universe for derived indexes such as factor or ESG indexes. Rebalancing these indexes allows changes to trickle down to derived indexes and aims to help avoid tracking error arising from benchmark misalignment.
While significant shifts in equity markets may highlight a need for index reconstitution, they may also raise concerns around excess turnover and the likely associated trading cost. MSCI Global Investable Markets Indexes aim to provide sustained and appropriate market representation without significantly higher index turnover. Our analysis showed that, with the help of implicit and explicitly applied buffers, the May 2020 index turnover was similar to that seen in past SAIRs, even in the face of current market volatility.
(The views expressed here are those of the authors and do not necessarily reflect those of ETF Strategy.)