Morgan Stanley Capital International will catapult China to around 10% of MSCI's main regional index from less than 1% currently.
MSCI said that from June 1 it intends to add 15 Chinese companies including several red-chip stocks to its China Free and various other indexes such as the MSCI AC Far-East Free Ex-Japan index, its key regional benchmark and the region's most closely followed.
Red-chip stocks are concerns that are incorporated in Hong Kong but do most of their business in China and are affiliated with mainland Chinese authorities. The huge market capitalizations of some of those companies, in particular China Telecom (Hong Kong) Ltd., means MSCI will count China's market capitalization at around $81 billion compared with $3.9 billion today.
"That puts it on a par with Singapore," says John Fildes, executive director of MSCI Asia Pacific. "It's extremely significant."
Because institutional investors rely heavily on the MSCI indexes, any changes have a big impact on the relative importance of companies and countries. The short-term effects, though, are hard to gauge. Even though changes to the China components of the indexes had been expected, and to a large extent already were priced into the market, analysts say that news like this would normally still give the market a boost. In the longer term, investors say the changes give red-chip companies in general a greater legitimacy, and should provide a particular boost to the ones included in the various indexes.
"It's saying these companies have the size," and the liquidity to be "investable," says Mark Shuper, head of regional telecommunications research at Morgan Stanley Dean Witter Ltd.
Morgan Stanley is making other changes to its key regional index. On June 1, MSCI is adding Malaysia back into the index, and increasing the weighting it gives Taiwan to 65% from 50%. But these countries aren't as popular with investors, so they might indirectly boost China stocks.
Taiwan has investment restrictions that are easing but still make it difficult for foreign investment companies to buy and sell stocks. "So, you're no fan of that," says Robert Conlon, chief investment officer of Investec Guinness Flight Asia, Ltd. "Malaysia has capital gains tax going out the country, so you're no fan of that, either."
But now that MSCI managers have introduced red-chip stocks into their indexes, "you'll like them for that," Mr. Conlon says. The companies that have been added, he says, are easy-to-trade, liquid stocks. He thinks eventually many fund managers may take overweight positions in China relative to the index.
Potentially, China Telecom was a problem for MSCI; had it weighted the company at its full market capitalization of $110 billion, it would have dwarfed the other stocks in the China Free index. MSCI got around that by weighting it at 40%, based on its free float, or the amount of stock that is freely traded on the stock market. The company still makes up the largest component of the China Free index.
MSCI took the same tack with Legend Holdings Inc., a personal computer maker, which has a market capitalization of around $10 billion. Its weighting is 80%, which is also based on its free float.
MSCI also announced that effective June 1, it would drop its China Free Domestic and Non-Domestic indexes and use only the China Free index. To make room for the red-chip stocks, MSCI plans to drop 20 companies from the China Free index. It also plans to move seven companies - including Citic Pacific Ltd. and Guangdong Investment Ltd. - from the Hong Kong index to the revamped China Free index.
After all changes are implemented, Hong Kong will remain the biggest market in the key regional index. But its weighting will decline to about 28% from 37% currently.
HEDGE FUND INDEXES
MSCI is also branching off in new directions; it has announced its intention to create a series of hedge fund indexes. The company is developing the indexes jointly with Financial Risk Management Ltd., a London-based investment manager with a database of 3,000 funds that will form the basis for the indexes. Richard Quigley, a principal with MSCI, said the move to construct the MSCI Hedge Fund Indexes was largely driven by client interest.
"Some of our largest institutional clients are starting to show interest in the (hedge fund) asset class," Quigley said, citing CalPERS as an example.
MSCI wants to establish itself as an industry benchmark in the field of hedge funds, Quigley said.
The indexes will be defined by strategy classifications that MSCI is currently in the process of developing. Eligibility will be determined by such standards as track record and performance history.
REVIEWING CAP WEIGHTING
MSCI also announced in February that it would review the use of full market capitalization weighting in its indexes. It has launched a study to examine alternatives such as adjusting company weights for low float and other ownership restrictions.
The increase in equity investing (particularly cross-border investing) by institutional investors, a growing interest in controlling the risk of portfolios relative to benchmarks, and the increase in initial public offerings by low-float companies motivated MSCI to look at alternatives to its present weighting system in order to find the best method for reflecting the investable universe in its indexes. Currently MSCI uses full market capitalization unless a very large company also happens to have low float. MSCI's partial inclusion policy allows for the company to be included in the index at a fraction of its total market capitalization. The company stressed no new weighting decision had yet been made.