One might think assigning a company to a particular country is easy.
Google? That’s from America. BT? It’s from Great Britain: Just look at the name!
But as with most things these days, even making this simple decision is more complex than you’d think. Globalization has crept not only into the world’s economy, but the capital markets as well.
What do you do with a company that’s headquartered in Holland, lists its’ stock in the US, and does 99% of its business in Russia? What about a company headquartered in a tax haven like the Bahamas? Chinese firms headquartered in Hong Kong?
In the world of indexes, this decision is important, because the goal of any index is to accurately reflect the strategy or segment it’s designed to track.
It’s important to note that the country decision is not only a critical step in building single-country indices, the implications are even wider reaching. For example, if an index provider is building a European index or a eurozone index, that indexer will make a list of countries that are eligible to be included. It therefore follows that attributing companies accurately to the right countries will make those regional indices more effective. The same goes for development-level indices (emerging and developed), continental indices (Africa) and specific geographic indices (BRICs).
The major index providers all use a slightly different process to assign a firm to a specific country, but the framework each uses is effectively the same.
The most common determinant of a company’s home country is the location of its headquarters. Since many companies are incorporated in countries with favourable tax laws—Luxembourg, Bermuda or Jersey—the country of incorporation can often be a misleading/inaccurate reflection of a company’s true location. As mentioned above, a company’s primary listing is not a perfect reflection of that company’s location either. In fact, many companies—particularly those in emerging markets—choose to list outside their home country because of superior market structure or capital potential.
To this end, most index providers use a combination of these factors to settle on a country classification. If these different components send mixed signals, a committee may be used to make a subjective judgment. Once all of these steps have been exhausted and a decision made, the indices can be built.
Most country-focused indices are cap-weighted, although there are some notable exceptions. MSCI is one of the most popular international index providers, and it often crafts its indices to be “investable”. Investable in this context has to do with concentration. In many countries, there are one or two firms that are significantly larger than any of their peers. They often make up more than 25% of the market cap for the entire country. In some extreme cases, they may account for more than 50%. In these cases, MSCI has built “capped” indices that limit the amount of weight any one firm can account for in an index. This process redistributes the massive weight of one firm to other firms in the country, providing a more diversified portfolio in the process.
Some index providers have even built country indices based on the amount of revenue generated in a specific country—an approach with a logical economic backing. This approach has a similar effect to capping—it limits the influence of dominant firms in smaller countries—but it also introduces different risks and exposures to the index. An index of firms generating revenue in Norway would include firms domiciled in other countries, listed in other markets and denominated in other currencies.
Ultimately, there’s more than one way to construct a country index, so it could be worth checking the methodology on your ETF’s underlying index if you favour one approach over another