When you buy an ETF, it’s important to understand how its index works as that is the main driver of performance. What’s less well known is that each index company divides up the world’s markets in different ways. So how do MSCI’s indices work?
How do MSCI’s indices work?MSCI takes a Russian doll approach to the world’s stock markets. The mother of all equity indices is the MSCI ACWI (All-Country World Index) which encompasses most of the globe.
Nesting within that index are various sub-indices which divide up the world into smaller pieces.
You could buy one ETF that tracks the MSCI ACWI and you’d instantly own a highly diversified portfolio. Or, you can use the smaller indices as building blocks to create your own custom view of the world.
The MSCI ACWI index covers 85% of the global market capitalisation. It tracks over 2400 large and mid cap stocks in 23 developed markets and 23 emerging markets. However, the share of emerging markets in the ACWI is only around 11% whereas they have roughly a one third share of world GDP.
Allocation of the world regions and countries according to MSCI
Source: MSCI.com; As of 31/08/2015
Many investors use GDP as a measure of the economic importance of the world’s markets which is why you may well prefer to build a portfolio based on some of MSCI’s regional or country indices.
MSCI’s World index covers the developed world’s stocks while excluding emerging markets. The developed world means the US and Canada, Western Europe including the UK but not Greece, the ANZACs, Japan, Hong Kong and Singapore in the Pacific plus Israel from the Middle East.
The market cap biasIt’s worth mentioning that the most reknown MSCI indices are based on a stock’s free float-adjusted market capitalisation. What does that mean? Free float refers to the amount of company stock that is readily available in the public markets. In other words, it excludes shares that are privately held by the likes of company executives, backers or government interests.
Additionally, a market cap index weights companies according to their market price multiplied by the number of (free float) shares. So if a large company is worth 10% of the entire index by market cap then it will account for a 10% portion of the index. If the company’s value doubles then the company will now constitute 20% of the index (assuming all other stocks were static). Some indices will cap the value of individual constituents to avoid excessive concentration.
The US accounts for the majority in the MSCI world indicesYou can see the concentration effect in action at a country level by looking at the weight of the US in world indices. The US market is worth 52% of the MSCI ACWI and 56% of the Developed World index at the time of writing. This degree of domination is another reason why many investors like to fine-tune their portfolios with regional and country specific ETFs.
One of the most important diversifying regional benchmarks is the MSCI Emerging Markets index. This contains the BRICs, Mexico, South Africa, Poland, Turkey, UAE, Malaysia, Taiwan and Indonesia among other notable countries.
Classification mattersSouth Korea is a particularly significant member of MSCI Emerging Markets as it’s classified as Developed World by FTSE.
Greece was relegated to the Emerging Markets by MSCI in 2013 while Israel was the latest country to be promoted to the Developed World.
Argentina dropped out of the Emerging Markets and into the Frontier division while Qatar and UAE came up the other way.
The Frontier Markets are the final tier of MSCI’s regional leagues and feature 24 countries including Serbia, Ukraine, Nigeria, Zimbabwe, Palestine, Vietnam and Pakistan.
Slice the MSCI World by market capThe indices discussed above cover large and mid cap companies in their constituent markets.
Large cap firms in the MSCI universe account for 65 - 75% of the total capitalisation of any given market. Mid cap firms form the next layer of the index and make up around 5 - 25%.
To get the 10 - 20% small cap slice on top of mid and large caps, look out for MSCI’s investable market indices (IMI).
MSCI index world by market cap
Source: MSCI.com; As of 31/08/2015
A good example of an investable market index is the MSCI ACWI IMI. This index features almost 9000 stocks spread across 46 markets and is about as diversified a choice as you can make. However, an ETF doesn’t have to hold exactly the same stocks as its index, so check the provider’s website to ensure you understand any differences.
However, an ETF doesn’t have to hold exactly the same stocks as its index. So for this huge number of stocks, it would be just too complicated and very expensive. Therefore, such large indices like the MSCI ACWI IMI are usually replicated by sampling. This means the provider selects the most important and most liquid stocks in the index which mainly represent the index performance.
You can also invest in individual countries using MSCI indices. Many investors do this when they want to overweight a particular country in their portfolio. For example, China constitutes less than 3% of an MSCI ACWI ETF. But you could tilt your portfolio towards China by adding an ETF on the MSCI China.
MSCI will often cap the weight of individual firms in an index to help reduce the concentration risk inherent in countries where a few mega caps might be worth 25% or more of the entire local market.
However if you decide to diversify, remember to check the factsheet for both the index and the ETF so you fully understand the role they will play in your portfolio.
You can find MSCI index ETFs by using the quick search or advanced filters in the justETF screener. Use the equity region or country drop-downs and look for ETFs with MSCI in the name. Or directly select the desired index in the index select box.
Investment Guides for the most important MSCI indices: