Single-Country Benchmarks And The Issue Of ‘Completeness’
The seven key criteria for index design should be adhered to regardless of whether an index fits into these new categories of active indexes or is a more traditional, “plain vanilla” product. While these criteria have become accepted wisdom among industry professionals, the issue of completeness still remains a challenge for index developers, particularly for single-country indexes and the investment products which track them.
Indeed, we would argue that many single-country indexes are glaringly weak when it comes to completeness, and that this weakness stems from a philosophical disagreement on the part of index providers as much as from practical, technical and operational issues.
This disagreement is readily apparent when comparing the index methodologies of established industry leaders for multicountry/global index families—namely, MSCI, FTSE and S&P Dow Jones—with newer index developers, some of which take different approaches to company nationality and classification. Global index providers such as MSCI and FTSE face unique challenges due to the breadth and depth of their index products. Not only do their indexes cover broad global market agglomerations (e.g., MSCI World, FTSE All-World), regional markets (e.g., Latin America, Asia and Europe, et al.), but single-country markets as well.
The issue of completeness arises due to a key cornerstone of MSCI’s and FTSE’s methodologies that “each security is classified in one, and only one, country.”5 Nationality classification is a key part of both index providers’ methodologies. Once countries are given a market status (e.g., developed, emerging, frontier), companies are allocated to a country based on measures such as where it is incorporated; its tax domicile; the location of corporate headquarters; major factors of production; and the currency in which the security is denominated.6
In cases where the methodology framework does not provide a definitive answer, MSCI, for example, uses the following elements to classify a company:
- “The company’s primary listing, secondary listings, if any, and the geographic distribution of its shareholder base;
- The geographic distribution of its operations (in terms of assets and production);
- The location of headquarters; and
- The country in which investors consider the company to be most appropriately classified.”7
In some cases, MSCI may exclude a company from all its indexes if the country allocation process results in a country other than the company’s primary listing. In practice, this most often occurs for companies incorporated in an emerging market, but that are only listed on a developed-market exchange.8 We look at this specific issue later in the paper.
Despite the rigorous methodologies followed by the major index providers and their best efforts to avoid misallocating securities to countries and indexes that are not truly representative of the underlying business, this frequently occurs in practice.
The case of South African Breweries provides an excellent example of this. The venerable South African company (it was first listed in Johannesburg in 1897), which, even after its 2002 acquisition of the U.S.-based Miller Brewing, derives almost 20 percent of its revenues from South Africa and more than 75 percent of revenues from emerging markets. Yet because the company shifted its “primary” exchange listing to London in 1999, the company, now called SAB Miller, is classified as a U.K. company by both FTSE and MSCI.9 Because of this, SAB Miller is not included in either MSCI’s or FTSE’s South African indexes, even though it has a 10.75 percent weighting in that country’s flagship Top 40 domestic equity index.