Moving Target

Adam M. Grossman

LAST MONTH, The Wall Street Journal ran an article with a puzzling headline: “How China Pressured MSCI to Add Its Market to Major Benchmark.” Like a lot of market news, this arcane-sounding story came and went without much notice. But it’s worth pausing to understand what it was all about—and why it matters to you.

First, let’s decode the terminology in the article’s headline: A “benchmark” is another word for an index. It’s simply a list of stocks or other investments. Probably the best known indexes are the Dow Jones Industrial Average and the S&P 500, but there are many others.

Who is MSCI? While less known than its competitors Dow Jones and Standard & Poor’s, MSCI is a major player in the index business. They have created thousands of indexes. Last year, the business generated more than $800 million in revenue.

While MSCI’s name is not well known, it’s an influential company. Thousands of index funds are built on its indexes. As a result, when MSCI adds a stock to one of its indexes, some funds are compelled to buy that new stock and this often drives up the share price.

Ordinarily, index providers receive little attention, instead operating quietly in the background. They move methodically and make changes to the composition of indexes only incrementally. In its most recent update, for example, the S&P 500 replaced just one stock out of 500.

But every once in a while, an index provider does something surprising. In the most recent case, according to the Journal, MSCI succumbed to pressure from China’s government to make sweeping changes to one of its best known indexes. China apparently requested that MSCI add more Chinese stocks to its Emerging Markets Index—an index to which trillions of dollars of index funds are linked.

This “request” was accompanied by threats, via intermediaries, that MSCI would see its business in China curtailed if it didn’t comply. According to the Journal‘s sources, MSCI had a hard time standing up to this pressure and soon after added hundreds of Chinese stocks to its Emerging Markets Index. They have added more stocks since and are considering adding even more.

Result: Over the past several months, emerging markets index funds have been buying billions of dollars of Chinese stocks—just as the government wanted.

As a financial advisor, I find this distasteful. There’s the principle of it. No one should bow to the demands of a repressive regime. Beyond that, radical index changes are unwelcome because they often carry tax consequences for investors. In addition, I believe the change detracts from the Emerging Markets Index, because it diminishes its geographical diversification. China already represented the largest segment of that index. Now it’s that much larger—and may get larger still. That, in my view, makes funds tied to this index riskier and less attractive as an investment.

As an individual investor, what can you do? Here are three recommendations:

1. Be vigilant. In recent years, index funds have exploded in popularity. Overall, I see this as a good thing. But the MSCI story is a reminder to remain vigilant. Just because an investment carries the word “index” in its name doesn’t automatically make it a good investment. Far from it. There are now thousands of index funds—some good, some bad, some terrible—so always know exactly what you’re buying.

2. Stay close to home. Many investment firms recommend investors allocate their dollars in proportion to the size of international markets. I don’t accept that notion. If you followed that prescription, domestic stocks would make up barely half your portfolio, with the rest distributed around the world. In my view, just because a market exists doesn’t mean you should feel any obligation to invest in it. Indeed, episodes like this are a perfect illustration of why I think investors ought to limit their exposure to international markets, especially emerging markets.

3. Look under the hood. These days, there are thousands of different index funds, many of which carry similar names, even within the same fund family. Consider iShares MSCI Emerging Markets ETF and iShares Core MSCI Emerging Markets ETF. It would be easy to confuse the two. A closer examination, though, reveals several differences—including a nearly five times difference in annual expenses.

Adam M. Grossman’s previous articles include No Free LunchPrivate Matters and Don’t Overthink. Adam is the founder of Mayport Wealth Management, a fixed-fee financial planning firm in Boston. He’s an advocate of evidence-based investing and is on a mission to lower the cost of investment advice for consumers. Follow Adam on Twitter @AdamMGrossman.

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