Market Index Destruction

March 24, 2008

''The fundamental impulse that sets and keeps the capitalist engine in motion comes from the new consumers, goods, the new methods of production or transportation, the new markets, the new forms of industrial organization that capitalist enterprise creates. ''The opening up of new markets, foreign or domestic ... illustrate(s) the same process ... that incessantly revolutionizes the economic structure from within, incessantly destroying the old one, incessantly creating a new one.

This process of Creative Destruction is the essential fact about capitalism.''
-Joseph Schumpeter Capitalism, Socialism and Democracy, 1942, pages 82-85

Schumpeter's principle of Creative Destruction is the ''essential fact'' of capitalism and modern capital markets. Since indexes are intended to measure these markets, index design must take Schumpeter's principle into consideration. In particular, it is expected that new companies will come into being, existing companies will either grow or shrink, and companies will change product lines, operations centers, revenue centers, stock exchanges and physical locations.

Similarly, investors will access these companies at different times based on liquidity, foreign ownership restrictions and other factors. Market indexes should anticipate and recognize the changes happening over time, which means that as countries and companies become available for global investment, they should be reflected in market indexes.

Companies Lead The Way

Unlike other market indexes, which include a sampling of stocks from a constrained list of countries, Russell's index reconstitution brings individual companies into the index when they are ready to be considered by institutional investors. Russell examines the size and liquidity of the security, the constraints on foreign ownership, the institutional framework and the economic and political stability where the security trades in determining investability.

An emphasis on the investability of individual securities, as opposed to an entire country's securities or industries/ sectors, simultaneously gives a market index a broader perspective and more ability to adapt to change. One example of this is the impact on new industries joining an index. Since Russell's index process is market-driven and does not constrain membership by requiring particular industry coverage, all sizable and liquid companies from new industries are added to the Russell indexes as they become accessible.
This process, combined with Russell's complete reconstitution process, tends to represent new industries earlier than other index providers; case in point, Russell was the first to include stock exchanges in its index family (e.g., the NYSE and the Chicago Mercantile Exchange).

In addition to better representing expanded industry/ sector exposures, Russell's index process also tends to include more companies within each industry. Because many index providers constrain the number of companies in their indexes, they are forced to select stocks from certain industries to simulate a market-relative industry exposure. This means that important companies from all industries can be excluded from market indexes that take a sector-based approach rather than a company-based approach to index construction. A few notable examples of companies historically excluded from popular sector-based indexes include Google, BMW and Microsoft.

Country Vs. Company

An expectation of market indexes is that they should measure the market. The globalization of the world's economies means national barriers become less relevant for investment decisions. Global market indexes, if they are to measure the market, should reflect this new environment. Some index providers constrain country membership and make large macro decisions on when to add a country to an index or when to move a country from one index to another. If the index provider decides to add a country, they will add, say, 85 percent of the market capitalization of the new country.

This is done regardless of whether or not all 85 percent of the country's equity market is accessible, or, in other words, is of global institutional investment size and liquidity. Frequently, this decision results in some companies which are not yet investable being added to the index before they are institutionally accessible and, conversely, many companies which become investable being left out of an index for a period of time.

One way for indexes to approach the emerging market problem is to look at companies instead of countries-like real investors do.

What About Emerging Markets?

The term ''emerging markets'' is a rather dated term coined in the 1950s to differentiate nations based on their degree of industrialization and per capita income. Sixty years later, the global investing landscape is significantly different, but the term and the indexes based upon them have persisted. Investors continue to allocate significant assets to emerging markets in the elusive search for alpha, but the concept of an emerging market has changed.

If a country was once designated ''emerging'' by a popular index provider, then all of the stocks associated with that country are considered ''emerging markets'' stocks. Moving countries to ''developed'' status within an index family means that all of the country's stocks are deleted from the emerging market index (plus all associated index funds) and added to the developed market index. Not only does this type of broad classification potentially misrepresent some of the stocks within a particular country, but it also limits an index's ability to accurately represent the actual investability of a country's market as a whole. Popular indexes are also, understandably, reluctant to make a change of this magnitude due to associated turnover costs, further distorting the ability of that index to accurately measure the market. This problem will continue to persist unless a different perspective is taken.

One way for indexes to approach the emerging market problem is to look at companies instead of countries- like real investors do. In local markets, investors have long considered stocks based upon their fundamentals, prices, size, style and industry/sector exposure. Why shouldn't global investors (and indexes) follow suit? In fact, global investors have been following suit and choosing stocks based on industry exposure and company fundamentals regardless of their home country. Samsung is one of the 70 largest companies in the world and one of the 10 largest companies in global technology. It does business in over 100 countries. But Samsung is based in Korea and is thus considered an emerging market stock by many index providers. This is despite its global business and large size, and despite the fact that it shows up in portfolios benchmarked against large-cap developed market indexes.

Ignoring the problems inherent in current global market indexes, investment managers are increasingly investing on a global or non-U.S. basis rather than on a developed or emerging markets basis. Some managers are specializing in large-cap or small-cap within the global or non-U.S. category. Most manager portfolios benchmarked against the MSCI EAFE Index look more like the Russell Non-U.S. Large Cap Index than the MSCI EAFE Index, because this particular Russell Index reflects large companies around the world-even those companies like Samsung in ''emerging'' countries.

Using a global benchmark that is organized by size rather than country means there will not be a disruptive decision made about when to transition Korea into the developed market index. Moving entire countries from one index to another causes disruptions to investment portfolios; in particular, index funds. Index philosophy that captures the investable universe gradually as market conditions change and as companies grow over time better represents the market both now and as it evolves.

Microsoft was a member of Russell's U.S. indexes for more than five years before it was added to the most well-known U.S. broad market index. If a company as significant as Microsoft isn't reflected in market indexes for long durations, imagine how many growing companies around the world are being missed.

Figure 1

As country capital markets grow, they are typically driven by relatively few industries. Limiting membership in global market indexes to only those countries with broad equity markets doesn't reflect how managers behave. Worse, it doesn't allow for the constant change occurring in capital markets. If a company from a country not previously represented in the index becomes investable, then the country should come into the index. It represents an investment opportunity in that country. The number of companies from the country will grow as the publicly traded companies in those countries grow and thrive. Conversely, as the market capitalization of industries and countries shrink, their proportion of the world market pie shrinks.

In the previous chart, we see the number of companies in the Russell Global Index from China, India and Russia has grown over the last few years, while the number of companies from Brazil, Hungary and Mexico has remained relatively constant. Russell's global approach ensures companies get added to market indexes when they become investable by global investors, not when some other arbitrary rule comes into effect such as ''there are enough companies from its country to justify putting the entire country into the index'' or ''Korea is now a developed country.''

To measure markets and provide the necessary context needed to evaluate the skill of investment managers, Russell builds indexes to reflect the investable universe of global equity securities. The force of Creative Destruction makes this universe a moving target. To stay on target, it is critical to have a process which both reflects and can accommodate for the changes inherent to global capital markets. If it does this, an index will be a reliable barometer for evaluating manager skill or can accurately be used as the basis for index funds.

Find your next ETF

Reset All