The coming of the euro means a raft of new indexes for fund managers to follow
Everywhere you look these days there's a new index. The financial community has hundreds of them at its fingertips to help it track the stocks of today and the winners of tomorrow. These range from the long-established and quoted-everywhere to the newly-launched and hardly-known. And as if there aren't enough already, new indexes are being introduced nearly every day - the impending arrival of the euro is not designed to ease the situation.
Elliott Shurgin, vice president at Standard & Poor's and general manager in charge of index services, feels that there are probably too many indexes kicking around the financial world. 'In my view, the markets have become over-indexed and I'm not sure why. It may be that banking and financial services organizations are using new indexes as marketing tools, ways to get their names known among a wider audience and expand their other, more profitable, operations.'
Many investment professionals share his view on the growing numbers of indexes, although they recognize the value of several of the local or regional ones. Sandy Rattray, head of European equity derivatives research at Goldman Sachs in London, doesn't believe the markets are over-indexed, but he holds that only a handful of indexes are of fundamental importance. He draws attention to the case of one German investor who told him that it felt as if there were more benchmarks than stocks. 'But then the Deutsche Borse launched the Dax,' says Rattray, 'and the other indexes fell away.'
There is also concern that those indexes purporting to measure the same region report differing returns over the same period. Why? Subjective influence on a scientific approach, perhaps. For instance, the MSCI UK index doesn't contain some leading UK stocks that are in the FTSE equivalent. Equally, the MSCI German index doesn't take in all those stocks that are in the Dax-30. British Petroleum has long been a constituent of the FTSE 100 but the MSCI compilers refuse to let it into their lists, largely on the basis that it is non-US owned. This is despite the presence in the US list of European competitors such as Royal Dutch Shell.
Great impact
This can have a marked impact on ownership patterns, says Peter Hall, investor relations manager at BP. 'Ownership of BP shares in the US is below that of our peer group. Other companies in our industry are held more widely in America.' This means that BP has to raise its US profile in other ways, he says. There is a solution, he has been told. If the FTSE 100 were to include Exxon, then the US compilers would bring BP into their top list. Not surprisingly, he doesn't see this happening just yet.
What seems generally accepted is that inclusion in a leading index is a valuable goal for many companies. 'While all index managers say that inclusion involves no assessment of the prospects or managerial merits of a company, it is widely seen as some kind of seal of approval,' says Hall. 'Stockholders and fund managers tend to see inclusion as positive.'
The market usually draws a strong inference from a company's presence in a top-notch index. As Shurgin points out, 'We try to add companies that are representative of their sector and we only add those that are thought to have long-term viability.'
Price bounce
Another positive effect is the stock price bounce that can arise when a company joins a major index. There is a clear and tangible reason in most cases, because index-tracking funds have to buy into the stock. 'There can be something like a 5 percent rise in the stock price,' Shurgin reports.
This price impact was obvious when the FTSE information technology index was announced late last year. For some time, high-tech companies and investors had been pressing for the creation of a separate sector for IT stocks listed on the London Stock Exchange. The arguments for such a division centered on the fact that the general run of investors neither understood nor trusted the burgeoning IT companies, and past failures had left them wary of the industry. Having a separate sector, with a full range of benchmarks, sector analysts and easier inter-company comparisons, would likely lead to a fundamental reassessment.
The creation of the sector, and the subsequent news of the launch of an IT benchmark index by FTSE International, was well-received and stocks on the list rose by an average of around 6 percent following the initial announcement.
FTSE's managing director Mark Makepeace says that they were encouraged by the positive response to the introduction of the new IT sub-sector and its own index. 'We believe that this move and other planned developments will help raise the profile of information technology companies.' Introduction of the sub-sector index had been planned for later this year, but the scale of the market's response to the creation of an IT category in the share classification lists resulted in FTSE bringing forward its plans. So the IT index was up and running from day one of the new classification.
In the club
But if indices and associated tracker funds continue to grow apace, does that imply the investor relations function will wane accordingly? After all, surely there's little point in IR when a fund is locked into or out of your stock?
As one might expect, many investor relations managers are prepared to defend their corner. They say that a company's presence in a leading index can lead to an increased communications burden and promotional activity. Apart from the continuing scrutiny of the index compiler, anxious to maintain the integrity of its list, there is heightened attention from the rest of the investment community's range of analysts, commentators and even active fund managers.
There's a significant IR advantage to being included in an internationally-recognized index, believes BP's Peter Hall. 'It's good to be in, if only because so many institutions measure companies by relative performance. Comparison with a large cap or sectoral index is fundamental for the institutions, and it's even more important for the index-tracking funds.' Individual shareholders have different criteria, Hall says. 'They're not too bothered about indexes and comparisons. They look at absolute numbers and are driven by them.'
Those sentiments are backed up by others on the Continent. 'Once we joined the principal index we started getting increased requests for shareholder information, briefings and business updates,' reports one satisfied French investor relations executive. 'And the extra attention helps keep us alert and has driven the growth of our IRprogram.'
However, Michael Waring, BAA's investor relations head, doesn't think that a long-run presence in a leading index makes a great deal of difference, He believes that any positive effect only occurs on the relatively rare occasions when a company joins or falls out of the index. 'It's just part of the process,' he says. 'Sales and brokerage people tend to focus on indexes, but it can't be a major force in determining their activity. At best, it'll act as a guide to marketing, perhaps.'
Like others, Waring regards the proliferation of indexes as not very helpful. 'It's just like having different financial evaluation techniques. In time, you come back to a preferred one.'
Alastair Ross Goobey of Hermes, which uses index-tracking extensively, says that around ú16 bn of the funds in Hermes portfolios are passively managed with indexes and quant strategies. On a ballpark estimate, Hermes controls around 1.5 percent of the entire UK equity market and embraces full indexing.
'We use the indexes as benchmarks,' he says, 'and set our managers' targets accordingly. If you beat the index consistently, then you end up in the top quartile of your peer group.'
Although Hermes replicates the FTSE All-Share index, Ross Goobey is anxious to emphasize the fund's commitment to the companies in which it invests. 'Because of our use of the benchmark index, we have a long-term relationship with the companies. We eschew the so-called Wall Street walk. If there are problems, we'll want to do something about it.' By implication, investor relations officers are going to be needed to act as a communications point between companies and those investors locked into their holdings through an index fund.
Easy option?
S&P's Shurgin thinks that index-trackers have generally taken the easy option, but he understands their reasons. 'There's always a lot of criticism leveled at passive managers, but with large cap companies in particular it's fairly difficult to beat a major index like the S&P 500.' He believes that the situation is different for emerging and small cap companies, where an active manager can more readily outperform the index.
Rattray points out that considerable investment sums passively replicate the market benchmark. 'In the UK, for instance, around £70 bn - some 7-8 percent by value of the UK equities market - is invested in FTSE All-Share constituents.' He puts this preference down to a move toward more of a risk-controlled approach by the investment community. 'Where funds are strongly benchmarked, there are stocks that have to be held. When Halifax came into the FTSE indexes at a relatively high weight, institutions had to take positions in the stock, even if they weren't particularly keen.'
A further reason for the preference for index constituent stocks, he reports, is the behavior of some regulators, who insist that funds invest only or predominantly in index stocks.
Regional concentration
Reliance on index-tracking and benchmarking is still seen as very much an American and European approach to investment management, however. While US and UK fund managers are regarded as doing well if they outperform the index, however badly that index itself might have performed, the situation in Asian markets is very different.
'Local investors in the Far East tend not to be very benchmark oriented,' Rattray says. 'They regard a negative return as a bad outcome, even though the benchmark index may have performed worse.'
In common with many analysts and observers, he sees the year ahead as being a crucial turning point for indexes worldwide. One oft-repeated phrase circulating around the markets is that '1998 is going to be the year of the battle of the benchmarks'.
Rattray draws particular attention to the launch of the Eurax and its regional and worldwide variants. The new index, alongside leading benchmarks such as FTSE International's Eurotop 100 and 300 indexes, is likely to emerge as a very significant yardstick. Institutional money will doubtless flood into them; and retail money could also be attracted as the private investors reach a new level of computerized sophistication.
There is substantial danger lurking in the growing commitment to benchmarking, however, particularly for the novice private investor. Of their nature, indexes may be manipulated comparatively easily, albeit often unintentionally. For example, JP Morgan fell foul of the London Stock Exchange's rules last December and agreed to pay a fine of £350,000 for causing a 35-point drop in the FTSE index on the last trading day of the previous month. Two Morgan traders had dumped a large basket of stocks onto the market at the end of the day and eager funds bought up lines of stock at virtually discounted prices. It took just two minutes for the index to plummet.
The exchange has since tightened its market manipulation rules, and Morgan has fired the traders. Nonetheless, in a world where investment decisions, fund management success, corporate results and even remuneration packages are determined by performance measured against an index - however well constructed that index may be - the scope for massaging and tweaking is huge. Mind you, it could also mean that the role for IR officers remains just as vital - index, or no index.
New entrants
The indexation/tracker fund craze has undoubtedly gained a lot of fans in the bull market fever led by the US over the last few years. Only time will tell whether the doldrums of a bear market will have the reverse effect on the US and Europe. For the moment, at least, there seems to be no stopping the new indices revolution.
Just look at the list in recent months. Two disparate families of indices were unveiled within the space of a week in January. The Euro.NM network launched an official all-share index covering the shares on each of the four constituent markets in Paris, Frankfurt, Amsterdam and Brussels. There is also a sub-index for each individual market, and each of the five indices will be calculated on the basis of both price and performance.
A few days later, the Financial Times launched an FT Sports Index covering London-listed football clubs and sports-related businesses. Each sub-sector will also have its own index. A quick head-count in that paper's markets pages at the end of January reveals a plethora of national and regional markets indices. All told, there were nearly 200 indices for readers to play with.
The Eurotop indices, launched last year by the Amsterdam Exchanges and FTSE International to replace the former Eurotrack benchmarks, will face a formidable competitor this year. In collaboration with Dow Jones, the German, French and Swiss exchanges are introducing a new series of equity indices, provisionally called the Eurax.
There will be two broad Eurax benchmarks: one covering shares from all European currencies and one taking in only shares from Emu-participating countries. A spokesman says that the indices will cover around 80 percent of each country's equity market, and that Dow Jones was chosen as the exchanges' partner because of its wide international benchmark-calculation experience. In the producers' view, the Eurax will rapidly become the benchmark index for the whole European region.
Others may have something to say about that. The euro will be the unit of calculation for another competitor. A new index for the European region is being launched by FTSE International, Goldman Sachs and Standard & Poor's. Initially to be calculated in make-believe euros, the index will move to actual euros when the currency is launched next January. Associated indices will cover European countries outside the so-called euro-bloc and the world excluding the euro-bloc.