Dominating An Index Is OK, Dominating An Index Fund Isn’t

April 01, 2000

It's not uncommon for local stock exchanges to be dominated by certain stocks. Nokia is a famous example, constituting roughly three quarters of Finland's total market value. But in some countries this does not sit well with regulators, and that promises to become a problem as the practice of indexing becomes more widespread.

The UK and Canada are now faced with mega-companies that dominate their indexes. In these two countries that have adopted index funds with enthusiasm it is index fund managers who are now bearing the brunt of the problem because of restrictions on portfolio holdings.

In the United Kingdom, the recent merger between Vodafone Airtouch and Mannesman has played havoc with index funds. Vodafone has a recent market capitalization of £181.2 billion and represents 13.5% of the FTSE 100 Index, the main benchmark for the UK.

Canada's S&P/TSE 60 is now dominated by BCE and Nortel which, as of early March, represented about 19% and 26% of the index respectively. Only a few funds track that particular index, with most index funds in Canada following the larger TSE 300, but even there Nortel's weighting had exceeded 15%. It has gotten worse: BCE had a 39% interest in Nortel and decided on a spinoff that took place on May 4.

In Hong Kong, where index funds are so far less prominent on the financial landscape, the Hang Seng Index has three stocks each representing more than 15% of the index. Active managers have found it difficult to keep up with the index, mainly because of the strong growth of HSBC which currently represents over 19%. They are prevented by regulations from investing more than 10% of their funds' assets in a single stock. However, the Hong Kong TraHK Fund, managed by State Street Global Advisers, filed for an exemption and can invest fully in the company.


Canada has a restriction that prohibits a mutual fund from having more than 10% of its net assets invested in a single company. As of March 17, the Canadian Securities Administrators, the organization of the securities regulators of the provinces and territories of Canada, announced it would be changing that restriction for index mutual funds, though it has not yet decided on the modifications it should make. The organization had said that it is seeking opinions on whether or not there should be any restrictions on an index fund's investments in a single company.

Standard & Poor's says it has no present plans to modify their indexes to fit existing investment rules, though it has discussed the possibility of introducing capped alternative indexes.

Until a decision is made, the Ontario Securities Commission has said it will grant exemptions of up to 25% to index funds affected by the 15% restriction.

If Nortel and BCE grow to the point that they exceed the CSA's exemptions however, said Gaetan Meloche, Manager, Finance Research and Product Development at National Bank Securities, a division of National Bank of Canada. the only way to try to limit their S&P/TSE 60 fund's tracking error with the index would be to invest in iUnits, shares of an exchange traded fund that tracks the S&P/TSE 60. The iUnits are exempt from weighting restrictions, according to Barclays Global Investors Canada, the manager of that fund.

Interestingly, the CSA's announcement specifically stated that actively managed funds would not be included in the exemptions and that it was not "convinced that it is appropriate to amend the concentration restriction for actively managed mutual funds."

This brings up the question of whether it is fair or not to effectively tie the hands of active managers.


The European Commission, of which the UK is a member country, has limited the amount of net assets a fund can invest in one issuer to 10%.

Relief may eventually be available; the European Commission has been debating easing the restriction. Originally a 35% limit on single stock investments was proposed but that suggestion has since been reduced to 20%. Jackie Blyth, speaking for the UK's Financial Services Authority, expects a decision to be made in the first half of this year.

    Company's Market Company's weight
Country Company Capitalization ($000) in country index (%)
Australia News Corp. 28,226,939 10.699
Austria Bank Austria 4,305,396 21.353
Belgium Fortis 18,374,715 18.758
Brazil Telebras 31,204,310 38.172
Canada Nortel Networks 172,412,129 28.209
Chile Petroleos de Chile 6,456,639 14.024
Denmark Tele Danmark 19,462,827 25.675
Finland Nokia 245,668,724 73.945
France France Telecom 176,205,091 14.724
Germany Deutsche Telekom 243,136,628 24.574
Greece Hellenic Telecom 14,329,704 15.140
Hong Kong China Telecom 108,978,171 26.796
Indonesia Telekomunikasi Indonesia 4,893,527 20.851
Ireland Elan 12,986,066 21.161
Italy Telecom Italia Mobile 81,317,419 13.414
Japan NTT Mobile Communication 391,711,621 10.513
Malaysia Telekom Malaysia 12,383,881 9.934
Mexico Telmex 38,256,975 33.287
Netherlands Royal Dutch Petroleum 124,988,771 21.127
New Zealand Telecom Corp. of New Zealand 7,928,125 43.593
Norway Norsk Hydro 10,068,291 26.447
Philippines Ayala 2,639,720 23.795
Portugal Portugal Telecom 13,378,466 21.338
Singapore DBS 15,741,365 15.419
South Africa De Beers Consolidated Mines 9,378,462 7.597
South Korea Samsung Electronics 45,428,427 23.671
Spain Telefonica 82,296,825 25.654
Sweden Ericsson 157,640,389 49.569
Switzerland Novartis 98,583,772 17.996
Taiwan Taiwan Semiconductor 25,881,021 13.931
Thailand TelecomAsia 1,527,283 11.150
United Kingdom Vodafone AirTouch 326,297,146 13.458
United States Microsoft 553,015,525 4.101
Venezuela CANTV 1,492,506 42.453

The 10% rule is "basically there to protect investors because rather than putting all the eggs in one basket, it's spreading the risk," Blyth said.

In any case, it seems the problem is far from disappearing. Megacompany Vodafone will soon share domination of the index with BP Amoco, a traditional heavyweight in the index and the company that will be created by Glaxo Wellcome's merger with SmithKline Beecham, should it be completed.

The FSA has been recommending that fund managers utilize a sort of sampling method to compensate for any increase in tracking error that might be caused by the 10% restriction, Blyth said. Rather than simply limiting investments at 10%, fund managers can try to make up the difference by investing more of their assets in another component stock in the same sector as the overweighted component and hope they perform in a similar manner. Because of the unusual circumstances, the FSA has waived a requirement that fund managers notify investors of any changes in investing strategy in their fund. An index fund manager trying to track the index only has to let the FSA know that he is modifying his strategy.

Tom Crombie, chief investment officer of Scottish Equitable Asset Management, said as a result of the restrictions the firm's FTSE 100 index fund "is not going to track the index very well for that one stock."


FTSE International itself has responded to the issue on its own and begun offering capped versions of its indexes. Simon Keane, recently retired Professor of Finance at the University of Glasgow in Scotland, says this confuses the purpose of an index, which is accurate representation.

"It is for the investor to adjust his portfolio if the index is perceived to be inefficiently diversified," Keane says in an e-mail. He is also skeptical of maneuverings by index fund managers to avoid tracking error.

"The merits of precisely tracking an index are limited. If the purpose of the fund is to provide a passive portfolio, then it certainly is not desirable to incur costs simply to avoid tracking error," he writes.

Keane believes that while it is entirely reasonable to protect investors from funds invested disproportionately in one or two companies, the restriction should take into account the weighting of the company in the index. The UK's rule would be more acceptable, he says, "if it prohibited investing more than 10% in a single company unless the company's weighting in the index itself exceeds 10%, in which event the limit should equal that weighting."


Keane further states that megamerg-ers such as the Vodafone-Mannesman merger do not necessarily mean an increase in the risk of the index because the giant created often increases the index's asset base.

In the face of a large merger, "the smaller the index, the greater the distortion," Keane says. But at the same time, narrow indexes are likely to be more risky than broad ones, and a megamerg-er can serve to effectively broaden the index, an advantage that offsets the distortion it creates in the index.

"It is important not to assume that a megacompany is just as risky as any other company," adds Keane. "It may have its own internal diversification."

Robert E. Ginis and Binu George, International Equity Strategists at Barclays Global Investors, agree with some of Keane's assessments. "The problem isn't really so much with index design as the regulatory environment which prevents holding of a company greater than 10% of a portfolio. So the indexes really are trying to reflect the reality of the market place but you can't purchase stocks past that 10% limit," says Ginis. BGI is wrestling with the question.

"There's no obligation for index providers to create indexes to fit (a country's) rules," says Sheldon Gao, Director of Product Development at Dow Jones Indexes. "But the trend is more and more that index providers consider this issue when they create an index. There is no rule to force them to do so, but they will in order to broaden the index user base." Licensing for use in indexed, regulated financial products is becoming too important a business for many index providers to ignore.

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