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Double dip

Two months before a second wave of changes to the EAFE, markets are relatively quiet - for now.

Two months before a second wave of changes to the EAFE, markets are relatively quiet - for now.

By Kerry Hannon
April 2002
Institutional Investor Magazine

As they anticipate a second and final installment of changes to the MSCI Europe, Australasia and Far East index - the first came in at the end of November and the next will hit the market on May 31 - money managers are assessing the index's makeover. On the whole, they like what they see.

"The benchmark was due for tweaking," says Binu George, international equity strategist at Barclays Global Investors. "This version of EAFE is broader and deeper than its predecessor."

"It's a better index," says Sandy Rattray, head of U.S. equity derivatives research at Goldman, Sachs & Co. "The job of an index is to replicate the investable market, and EAFE does that better now."

The first round of changes, which took effect on November 30, involved 210 additions to and 91 deletions from the index, announced last May. Next month Morgan Stanley will complete the changes in the index's country and sector weightings. The firm declined the opportunity to speak about the index or the changes.

The first shift did not play out as many had expected - at least for speculators. Well before November 30, index funds had quietly traded certain shares to position themselves for the EAFE changes; hedge funds and others, meanwhile, had amassed considerable positions in stocks that would be added to the index. Ultimately, speculators held a much greater supply of the stocks that were joining the EAFE than indexers actually needed.

As a result, Barclays' George recalls, "trading imploded," and additions to the index underperformed the deletions, for both the week leading up to the switch and on November 30 itself. In the week of the rebalance, the adds underperformed the deletes by more than 3 percent.

"People got burned," says George.

For years investors and money managers had griped that the EAFE index included too many illiquid shares - shares that were owned by a families or governments that would never actually trade them. As a result, a stock's market capitalization might appear to be huge, but the number of shares available for trading was actually minimal. Morgan Stanley did adjust the relative weighting of stocks in the index from time to time to reflect their free float, but in a "modest and ad hoc" way, says George. Rival indexers, including Dow Jones & Co. and FTSE, better reflected the markets' free float. But the newly constituted EAFE more "precisely and systematically" adjusts for free float, says George.

One result: The EAFE now covers 85 percent of float-adjusted market cap - the same as the FTSE - versus 60 percent of total market cap (which includes illiquid shares) before November 30.

Goldman's Rattray believes that the changes strengthen the EAFE's position as the leading foreign equity benchmark. "If you're a fund manager looking for a benchmark, you need a good reason for not using the EAFE," he says.

On a country-weighted basis, the U.K. is the main beneficiary of the changes in the EAFE lineup, with a 5 percent gain in its weighting. France, Germany and Italy saw the largest losses - down 1.7 percent, 1.5 percent and 0.9 percent, respectively.

The five stocks that saw the greatest increase in their market weighting: Shell Transport and Trading Co., NTT DoCoMo, BP, Vodafone Group and GlaxoSmithKline. The largest weighting decreases hit France Télécom, Toyota Motor Corp. and Deutsche Telekom - stocks with a substantial number of restricted shares.

The most visible change in the index was probably the appearance of Japan's NTT DoCoMo, the wireless subsidiary of parent company Nippon Telegraph & Telephone Corp. When DoCoMo joined the EAFE, NTT's weighting in the index fell. In the weeks preceding the index change, speculators bought up shares in DoCoMo, but they misjudged demand, and as a result, by November 30 DoCoMo shares had underperformed those of NTT by 4 percent.

Some market observers anticipated that the change in the EAFE would impose very high trading costs for the week or so around the time of the change. Lehman Brothers estimated that the first phase of the EAFE rebalance would cost 80 basis points - reflecting the expense of buying and selling the shares needed to bring portfolios in line with the revised index. Citigroup/Salomon Smith Barney's Global Equity Index Group predicted that the "massive MSCI conversion likely will generate 25 percent turnover each way (or 50 percent round trip [both additions and deletions]) in fully indexed MSCI EAFE portfolios."

In reality, trading costs were far more modest - about 30 percent round trip - because many index funds had gradually adjusted their holdings to reflect the new index roster well before the changes became imminent. They thus avoided the price run-ups some speculators had hoped for.

Less than two months before the next round of changes, the market is "much quieter" than it was two months before the first set of changes in the index, says one indexer, but that is to be expected. One Wall Street analyst reports that he has fielded "some inquiries from speculators," but nothing dramatic. Indexers will likely spread out their trading activity in the weeks leading up to May 31, much as they did before November 30.

But as that deadline approaches, "greed and fear will kick in," suggests Barclays' George. "Investors may be wary of trying to make profits trading on coming changes in the EAFE. But money managers may also feel that it's increasingly difficult to outperform the market - and they may see the EAFE changes as an opportunity. They may say to themselves, 'No one else is going to trade on this, so I can.'

"Of course, if everyone says that, it can't work."

Merger moves

In marketing to large pension funds, most money managers have traditionally kept separate departments to cater to defined contribution and defined benefit plans. But recently, some of them have begun to merge the two teams.

For money managers, it's a way to cut costs and bolster thinning profit margins. And in many cases, the clients prefer to deal with one cast of characters - and pay one set of fees.

During the last quarter of 2001, both Putnam Investments and Barclays Global Investors merged their defined benefit and defined contribution units. More investment managers will likely follow suit, says Joshua Dietch, a consultant with Cerulli Associates in Boston.

"It's a mature marketplace," Dietch says. "There's a finite number of plan sponsors out there, and there is some pretty serious overlap."

By combining defined benefit and defined contribution departments, Putnam and BGI hope to cross-sell to more of their clients, reap economies of scale and improve customer relations. The plan sponsor also gets to slice fees by as much as 50 percent, because pricing terms are adjusted to reflect the combined assets of the defined benefit and defined contribution plans.

"Bringing the two sides together is more powerful than having two separate sales forces," says Chris Cumming, vice president of marketing at Diversified Investment Advisors, an investment manager based in Purchase, New York.

Most of the largest plan sponsors already use the same money managers for both their defined contribution and defined benefit plans. Among plans with combined assets of $1 billion or more, 71 percent use at least one of the same managers for both defined contribution and defined benefit, according to a recent study by William M. Mercer.

David Holmes, a Mercer senior consultant, believes that for large plans that do use multiple investment managers, it makes even more sense to reduce the parade of sales representatives marching into the treasurer's office. According to Mercer, 102 of 159 large plan sponsors prefer a single contact person. "It's a lot more efficient and effective to have the same contact marketing to both plans," Holmes says.

At Putnam a client survey last year revealed the same sentiment: Plan administrators want one contact person. "A lot of our clients told us, 'I don't want to have to deal with a lot of people at Putnam,'" says John Brown, head of institutional management at the Boston-based firm.

Putnam merged its operations in December, combining 150 people from its defined benefit department with 200 in its defined contribution unit. When BGI combined its defined benefit and defined contribution divisions last October, it eliminated about 20 of 100 positions.

In recent years many defined contribution plan supervisors have been asking their money managers more sophisticated questions about asset allocation and investment strategy. In the past plan administrators had asked mostly about procedural and administrative matters. "We're seeing the sophistication on the defined benefit side roll over to the defined contribution side," says Peter Landin, chief executive officer of BGI's U.S. institutional business.

Conversely, investment managers also see an opportunity to leverage the knowledge on one side of the business in cross-selling to the other. Growth has been flat in the $6 trillion defined benefit universe for the past two years, and as a result, "firms are looking for the last reaches of the market they have not penetrated," says Mercer's Holmes.

But the impetus to cut costs at money management firms is probably the most powerful factor driving the trend. With two years of declines in the Standard & Poor's 500 index, assets are down, and so too are fees. "The downturn crystallized what they need to do," says Cerulli's Dietch. "You are looking to cut costs. And do more with less." - Charles Keenan