Analyzing the Jam Packed Calendar of Upcoming Index Events

Karl Schneider:
For mutual funds, this is going to be a pretty significant event. If you're going to have to sell a really large portion of your portfolio to fund some of these large additions to the portfolios.
Peter Haynes:
Welcome to Episode 80 of Bid Out, a market structure podcast From North of 49. My name is Peter Haynes and I'm the host of this podcast series and today we're going to revisit the calendar of index events that are impacting portfolio managers and traders over the next few months, including, of course, the elephant in the room and that is SpaceX and specifically efforts by index providers to ensure that benchmarks are fit for purpose for the largest IPO in history and the others that are going to follow later this year.
Joining me in this deep dive are two experts in benchmarks and indexing. Karl Schneider is a senior portfolio manager in the systematic equities group of State Street Investment Management, where he has some responsibility for a portfolio management team of index managers and Jeremy Lai, portfolio trader here at TD Securities with responsibility for covering the passive index users.
Jeremy and Karl, thanks for joining the podcast.
Karl Schneider:
Thanks for having me, Peter.
Jeremy Lai:
Thanks, Peter.
Peter Haynes:
Okay. Well, just before we get going, I want to mention to our audience, I've been quiet on Bid Out over the last couple of months, but we will get very busy here coming up over the next month or two, sort of in line with the index calendar. Next week I'm taping finally the podcast where we'll take a look at market on close auction facilities in the APAC region. Listeners of the podcast series will know that we covered Europe and North America last year and we're finally finishing off that round trip with APAC. And then there's a couple more coming later in June. And then I expect in July and August when we get some of the new rules coming from the SEC that we'll have things to talk about with some of the industry experts on market structure. But today it's all about indexing and I want to make sure our listeners know a little bit more about the careers of both Karl and Jeremy.
Karl, I'm going to start with you. Can you tell our listeners a little bit about your recent career history and your current responsibilities?
Karl Schneider:
Yeah, sure, Peter. And thanks again for having me. So I've actually been with State Street my entire professional career going on 30 years now. Last 27 of which have been as a portfolio manager on the equity index team. So I've certainly seen a lot over the last 27 to 30 years in this space. I spent a good deal of time specializing in different areas on the index portfolio management ecosystem. And now at this point, I help oversee the PM team here in Boston, which is about 25 portfolio managers and overall index assets for State Street is five trillion.
Peter Haynes:
That's a big number. And if I do my math right, 27 years means it takes you back to joining the index portfolio management team right at the start or in the middle of the tech bubble. So you have seen some of the plays that are going on right now in the past and certainly we'll test you out on some of your history with respect to indices as we go along.
Jeremy, let's talk a little bit about your career at TD Securities.
Jeremy Lai:
Thanks, Peter. So I have spent basically my entire career at TD over the past eight years, starting with yourself in the market structure index and ETF research group for three years and then transitioning to the trading desk where I've been for a bit over five years now, primarily focused on portfolio trading in the Canadian market with a particular responsibility for covering, as you mentioned, passive index users, be it the indexers themselves, the hedge fund community and those that care about index issues overall.
Peter Haynes:
Well, I'll certainly say that everybody is caring about index issues right now. It doesn't matter if you're a fundamental investor, you're a hedge fund pod, trading around index events or you're the long only indexers. Like Karl, everyone's caring about events because I would say the calendar in the next couple of months is as busy as we've ever seen it.
So I want to start with SpaceX. I know from Karl's perspective, we're going to keep things generic. Jeremy, I'm going to start with you though specifically on SpaceX because it is the name that is creating this new category of mega-cap companies and the index providers are reacting to that. So let's talk a little bit about the conversation in the non-index community. There's a feeling that the index providers are bending need to get SpaceX and the other mega-caps into the important benchmarks with rule changes that will allow all of those stocks to be fast tracked into indices in between 5 and 15 days post IPO. What do the index users think of these rule changes?
Karl Schneider:
Yeah, it's a great question and it really requires you to step back and think about what are the core tenets of indexing, especially broad market indexing, and why indices are constructed a certain way. And so those two core pillars or tenants that I think most people believe are what drives the decisions for index construction are the need for representation and for investability.
So representation, especially when we're talking about these mega-cap IPOs like SpaceX that are expected to be literally trillions in market cap are our broad market, especially the large cap broad market benchmarks truly representative when they don't include trillion-dollar companies that are listed for some time before they become part of the benchmark or perhaps never if you have a broad market benchmark like the 500 with a profitability rule. And so when this sort of lineup of large IPOs like SpaceX and others that are potentially coming down the pipeline started to become a potential reality, it became important for us to really consider whether these benchmarks would be continuing to be representative of the investible universe if they didn't have some method to accelerate the addition of these names. And so index users I think broadly are aligned in believing that an acceleration of the addition of these IPOs, these mega-cap IPOs in particular, is good for representation.
Now where there is some disagreement is on investability because as we know with IPOs generally only being a small percentage of the total shares of the mega-cap companies, investability is not always apparent and structuring index rules around how to affect these IPO potential fast track additions in an investible way, be it rules that are designed around flow and what have you, is where there's really a debate in the market.
Peter Haynes:
A great example of that is showing that the IPO is not investible is the IPO that just started trading literally minutes before we were taping this podcast, which is [inaudible 00:06:45], which I believe was priced at 185 and opened at 350. A great example of why you can't use the IPO price for determining the inclusion of a stock in an index it needs to trade for some period of time and we've settled in on 5 to 15 days.
But Karl, there is one benchmark provider that's always been a bit of an outlier and has been an outlier on this fast-tracking discussion and that is S&P for its US indices. And frankly, S&P really has been that outlier as the one provider that has required profitability, as Jeremy just mentioned, you have to be profitable in the last 12 months and the last quarter. So it means you must be listed for a minimum of a year and it also includes a discretionary decision-making process for ads and deletes.
A couple of weeks ago, S&P came out with its so called mega-cap index inclusion rules and for this constituency of $100 billion plus companies, it's going to waive the profit rule and it'll reduce the minimum wait time for inclusion for the mega-caps in the S&P 500 to six months from a minimum of a year. What do you think of these rule changes in this proposal?
Karl Schneider:
Yeah, to be honest, I actually have mixed feelings about their proposals. Completely agree with Jeremy about the indexes should be representative of the market that they're trying to cover. So if S&P is looking to make themselves look more like other indexes out there and be representative of the overall market, then they're definitely taking steps in the right direction. But when you drill down a little bit, they actually might not be going far enough with some of their proposals. So the seasoning period they're recommending going from their existing 12 months down to six, that could actually perhaps be shorter than they're proposing. So perhaps they can get the escrow unlock period to line up better with some of these IPOs coming out where the unlock period might be sooner than six months.
We potentially could have an issue with completion indexes with broad market indexes that are ex-S&P 500 companies if there's a large company that's not added to the S&P 500 in a timely manner and some of the size estimates that we've seen for some of these companies would be really, really significant weights in these completion indexes, which could cause potential issues down the road for taxable clients if they have these gigantic positions that they need to sell in order to facilitate the migration from a completion index to the S&P 500.
Then when you talk about the financial viability piece, maybe that should be removed for all companies and not just mega-cap IPOs. In general, I don't love it when there are exceptions to index methodologies. So a carve out for mega-cap companies does not necessarily feel right to me. I know what they're trying to do here, but it almost feels like they're kind of going halfway. They're not going the full way to be fully representative and rules-based like other index providers and they're not keeping the way it was.
And so you mentioned them being an outlier. The financial viability criteria and seasoning periods are unique to them, set them apart. The discretion of the index committee is unique to them, sets them apart. I know there's some talk about some of these things being outdated and they should be eliminated, but in reality, that's one of the biggest differences or really it is the biggest differences for S&P and it does set them apart. I think Tesla's inclusion a few years back and the feedback S&P received surrounding that event is probably in part the reason why this consultation is out now, but they do have an opportunity to stick to their guns and stay differentiated from every other index provider.
We're mulling over the consultation at the moment. It's not due for another couple of weeks, but mixed feelings. We definitely have some strong feelings on both sides of this argument here, but from myself, kind of mixed feelings, I can see the pros and cons of either side.
Peter Haynes:
Well, you mentioned the profitability test. It doesn't apply when there's a spinout. It doesn't apply when there's a migration. It doesn't apply when there's a merger. It's an outdated rule and you mentioned Tesla, I believe it became profitable by selling environmental credits as opposed to cars. And so it really is a gameable stat that we would agree, I think is outdated.
Jeremy, Karl touched on the completion index and this really became an issue around the Tesla inclusion when Tesla was a very large component of completion when it got added to the 500 index. Can you just dig in a little bit more? Where has this come from, this completion index and can you just explain sort of a little bit about how big SpaceX and some of these other mega-cap IPOs could be in the completion for a pretty long period of time?
Jeremy Lai:
Yeah. So for a way of background, the completion is essentially the TMI minus the 500. And so-
Peter Haynes:
What is TMI?
Jeremy Lai:
The total market index, which if you were to remove the 500 components naturally would be kind of mid-cap and lower companies down to there are over 3,000 members in the TMI. So the total index cap of the TMI without the 500 naturally being much smaller means that when you add a name like Tesla like potentially SpaceX and others that is all of a mega-cap size, its weight, especially if you are to fully represent it with full flow would become astronomical in the completion index, essentially not really belonging in a benchmark that is meant to be excluding the large caps of the US market. So initially with the IPO, if you only have the IPO shares, for example, represented, it already is in itself potentially a couple of percentages of weight in the completion, which is going to create unnecessary turnover, which has very meaningful tax implications.
But then even further down the road when you have the unlocks of the escrow, when the flow goes back into SpaceX and it becomes a much larger flow cap for the index, the implementation of that would cause it to potentially be over 10%. And that is not the intended experience for the benchmark and creates a lot of really, really destructive and problematic turnover and especially in consideration that if you think that SpaceX is not meant to be in the completion long term and it's just a sort of pit stop before it gets to the 500 at some point, it's entirely unnecessary for the kind of value destruction that it would create.
Peter Haynes:
If mega-cap IPOs are fast-tracked and the window of time is taken from six months down to a shorter window for eligibility, or even if it stays at six months, the fact is that those mega-caps will be added to the TMI after day five post IPO. What would be your solution to avoid that disruption of distorting the completion index and not representing properly in the 500?
Jeremy Lai:
I think that ultimately the potential decision to be added to the completion needs to be done simultaneously with the decision of whether it is added to the 500 on an accelerated basis. And so the results of that being that when S&P makes that seemingly discretionary, but in reality probably goes in one direction, because of the size of SpaceX, decision as to where it is placed will be just one or the other. Really, the ultimate thing that you want to avoid is this pit stop of temporarily having it in the completion and then removing it when in reality we know that it's extremely likely that it will just end up in the 500 at some point.
So I think that regardless of what you end up deciding, be it a six-month seasoning and then decision or ultimately a faster acceleration, the timing of the completion addition needs to match that. And essentially it's like a similar implementation where you are freezing potential additions of mega-cap names into the completion based on the definition of an IPO being mega-cap.
Peter Haynes:
Karl, one of the second order effects of S&P 500 inclusion for the mega-caps is that they will automatically be included in the funds that are linked both to the 500, obviously, but also to the sector where the mega-cap stocks are added. And this will also be the case for various specialty funds that require S&P 500 inclusion for eligibility. According to the classification rules, and again, this is me speaking, not you, it is likely that the first of these mega-cap IPOs, SpaceX, will be placed in the communications GIC and that's again because it generates the majority of its revenue from Starlink, which would then be a communications comp. And so this means then it will get added to any sector related funds linked to the communication sector. And once the entire float is included, SpaceX can represent as much as 10% of the communication sector.
I'm curious, as an index manager, do you think differently about approaching a mega-cap names inclusion in the 500 index and its inclusion in a sector ETF where it might have a much higher weighting?
Karl Schneider:
Yeah, sort of. Obviously the methodologies are going to be very different between the broader based S&P Five and the individual sectors. So we really need to pay super close attention to the projected weightings and the resulting knock-on effects like concentration, and benchmark capping and the 10% figure that you quoted would be a capped weight within the benchmark because there are certain diversification rules, SEC and IRS diversification rules that need to be adhered to for any of the registered products here in the US. And that's really been an important topic in recent years that these registered funds have to comply with these SEC and IRS diversification rules. Lots of indexes already have these guardrails in place in the methodologies. The ones that didn't over the last several years scrambled to get updated methodologies put in place so that the concentration and capping wouldn't make them run afoul of some of those things.
So certainly something that a sector index manager has to be aware of, that these are going to be really large weights. But one thing that we've seen over the last 5, 10 plus years, there's a ton of really large companies now in the US. And so there's a number of sectors that are being capped in order to meet these diversification requirements. And so these potential names that are going to be coming in are just going to be joining a list of existing companies that are already capped in some of these indexes.
The one other thing that I think we need to, I'll think about it in the S&P Five, but specifically more in concentrated indexes like this is that if a giant name is added, where are you going to get the funding to buy that name? And so largely that's going to be from selling other constituents within your fund or index and that's potentially going to bring some tax consequences if you're not careful in how you trade. And now in the US there are some mitigating ways to potentially offset some of these tax consequences, especially on the ETF side, but for mutual funds, this is going to be a pretty significant event if you're going to have to sell a really large portion of your portfolio to fund some of these large additions to the portfolios.
Peter Haynes:
It's so true. You think of the 500 inclusion, oh, it's 1% of the 500, it's 1.5%. Then you think of a sector and it's 10%. And at the sector level, all of a sudden it becomes a very, very big deal and that funding question has been a common one and it will be something with respect to the first of the mega-caps coming in June or July, whenever it happens, where it's going to come right down to a lot of math being done by the Street to figure out all the different benchmarks that are impacted and all the flows related to that.
So Jeremy, in our index research that TD has written, we've emphasized that the really big event on the index calendar is actually not SpaceX's IPO inclusion, but is in fact the release of locked up shares, which you mentioned a second ago, which will likely be somewhere between 10 and 15 times larger than the stocks float on its IPO. Further, this lockup release may not be three or six months, which is a normal schedule for an IPO. In fact, I think the Street's expecting that these lockups will be released much quicker than that period. Can you explain exactly how index rules work today for these lockup releases and do you think these rules are fit for purpose for SpaceX's pending lockup release?
Jeremy Lai:
Yeah. So for the most part, most major benchmarks, once the unlock is officially over and it will be pushed to the subsequent quarterly, assuming that the date of that unlock is before any sort of cutoff or freeze period. And so at the subsequent quarterly, that's when that unlock is reflected in the benchmark. S&P is really kind of the main exception with the annual treatment in September where floats are updated on an annual basis instead.
I think that there are a couple issues here. First, that the unlock itself generally not being a accelerated event in most cases would not on its own line up with the special treatment that may be afforded to SpaceX heading into its unlock period as people are trying to push it up sooner and sooner. And that perhaps is part of the impetus for S&P's proposal to leave a lot of discretion in the potential for the unlocks to be reflected in the benchmarks on an accelerated basis if they're over a billion dollars, but then basically leaving themselves carte blanche in the proposal to implement that how they see fit.
So it leaves a lot of questions that remains as to what is the best way to actually affect that and especially because S&P is leaving themselves the leeway to decide how to do it. It also leaves some questions as to what is the resulting effect depending on the structure of the company and the share class, potentially different share classes when the company goes public and what that might have an effect on for the flow increases when the lockups expire.
So I bring that up because there is a school of though, one that is not necessarily a certainty or proven or likely in one way or another, but potential that the company comes out and you have the IPO shares which are listed, which are freely trading and then you have every other share that's not part of the IPO part of an unlisted share class, one that is locked up and then when the escrow releases, those that own those shares have the ability to convert them into the freely traded shares. And so that structure would be very different than if all of the shares were theoretically part of the same share class of listed shares, the same as the ones as the IPO, but then you have very large control block on that same single share class.
The difference there really is that if you have a single share class when the escrow unlocks, and there's a formal date for that, you can have upon that event basically a subsequent quarterly or some sort of like future event whereby that is basically it's because the date is known, you will then have certainty that that float is going to come back into the index. But in a structure where you have an unlisted share class, you actually need the holders of those shares to opt in to convert them into the listed share class to increase the flow. And so the data release of that probably comes out on like a US filing like at a quarterly or what have you, which actually delays the process.
And so even if S&P were to want to implement some sort of discretionary implementation of a flow change, which they had been providing, if it's large enough over a billion dollars they would want to have on an accelerated basis, you would not be able to actually do that until you get the data for what shares have been converted into the listed share class. So that difference, it makes some difference for the S&P treatment.
Peter Haynes:
The technicalities around each of the benchmarks and what's MSCI's rule book now, 800 pages or something like that. It is insane to be an expert or to try to be an expert on all these different rules and I think we'll learn a lot more, all of us when SpaceX's S1 is filed.
And just before we put that topic to bet about traunching, which I do think the other providers need to think about, I think S&P allowed themselves traunching for the escrow release thinking that that would be the big event and they would need some flexibility. Based on their rule proposal and how we think the escrow will come out, the escrow will all be released when it's potentially included in the index. So I think S&P needs to amend that flexibility on traunching to actually the inclusion of the mega-cap name. That was the problem on Tesla, as Karl remembers very well, was that it was just too big for the market to absorb all at once. And in hindsight, I'm sure we all wish they had have used some sort of a traunching model for inclusion. So I really think S&P needs to consider making that change.
Jeremy Lai:
Yeah. And I think ultimately what is best for indexers when it comes to this very likely historic unlock period in terms of notional size is that there is a period where there is price discovery and full ability for unlocked shareholders to be in competition to basically sell their stock if they desire and view that the current share price is a level where they don't necessarily want to wait for a future demand event, which is going to be the indexers buying the shares and can then have the price discovery period be one that is not affected by those that are unable to sell.
And so that's very important I think for indexers to not feel like they're the last ones holding the bag, so to say, on a very, very large notional event because if there's full competition from people who have held SpaceX forever and are up tons of money and seemingly with the stock trading at a certain level may desire to sell it before the demand event and not just be waiting till the end, then the competition allows for price discovery and so it's a better experience for the indexers.
Peter Haynes:
Well, Karl, you said you had 27 years on the index portfolio management team, so that allows me to test you a little bit on your memory. How about I take you back to when S&P made the decision after MSCI, I believe, to move to floats from total capitalization. Do you remember that, I know it was traunched in for MSCI, I think it was traunched for S&P in the US. Were you actively involved in that process and do you recall whether or not there was any reluctance to want to make that move?
Karl Schneider:
The flip side of being here a long time and having institutional memories as you get older, some of your memory goes.
Peter Haynes:
Yeah, I know that.
Karl Schneider:
I do remember the change to float cap methodology. I believe you're correct in that it was traunched in. Yeah, I mean, that was a fairly significant change and the correct change, especially when you have the benefit of hindsight looking at it.
It's interesting when you think about the current things that are under consideration now in five years from now, are we going to look back and say, "Well, that was obvious. Of course, all this should have been done at the time or even sooner potentially." The benefit of hindsight is always a wonderful thing, but something to think about when we just want to project indexes and the methodologies going forward and trying to think of like, do these proposals make sense, not just S&P, but kind of all the proposals that have come out recently.
Peter Haynes:
Representative and investible and you're absolutely right. In hindsight, you think, "How could we not have gone to float around the world?" We had float in Canada right back from when the composite was launched in 1977 and even before that with the old benchmarks. So it's been something we've been comfortable with in the Canadian market. I'm really glad that move was made globally. It was absolutely needed. There's Asian markets where it's a big deal as well.
And then there was that name called Walmart, which was always an issue of being around 50% float and then that was a inclusion rule at one point. So you had to have a minimum of 50% of your shares in the float. So these are all triggering memories, not all of them good. But yeah, you're right. Imagine if we were thinking about total cap, even NASDAQ had to change their rule in the case of the mega-caps here because of the fact that such a small percentage of those mega-caps will be, or at least the first one will be available to the public. They've had to come up with a new model for how their benchmark works, being the only one really that was left using total cap and not float.
Karl, you mentioned classifications earlier and I want to loop that into a discussion around style benchmarks as well. These both have become a big topic with the rise of the MAG7. And this MAG7 explosion impacted a lot of sector funds and caused fundamental managers, active managers using the Russell 1000 growth in particular as a performance gauge a lot of consternation. You mentioned capping. Index providers generally use, when they're thinking about style, index providers generally use quantitative metrics such as price earnings ratios, price to sales, forward-looking earnings, et cetera, in order to determine style. And there's a big one coming in June where the expectation on the Street is that Amazon will move from a one quarter value rate now to 100% value and this style change is going to represent like a 5% weighting adjustment from growth over to value and this is massive.
And then if you think about IPOs in terms of the fact there are no forward metrics, the index providers are using sector comps. And in the case of communications, all of these sector comps are actually value stocks. So SpaceX will be considered a value stock on day one unless the rules change and we actually, the more we think about it, the more we think those rules do need to change.
I'm curious about your own experiences. And you mentioned a little bit about some of the capping issues around sector funds and the classifications. I know in the case of SpaceX, a lot of people thought maybe it should be an industrial, which would have very different implications for that industrial sector. And also on style allocations, do you think the index providers determining style should actually maybe be thinking about discretion on some of these mega-caps and maybe put them where they belong in growth and not value?
Karl Schneider:
Yeah. I mean, in general, I think I said it before, but I'm not in favor of making exceptions when there are clear sets of rules. If the rules are there, they should be laid out and followed. If there is a concern about the current methodology, then we should be looking at changing the rules around it, not carving out exceptions for certain pieces of it. So the GIKX sector classification framework in general I think is pretty good. So probably want to keep that in place or don't completely overhaul it, but maybe there's some tweaks needed there and IPOs I think are a good example of something that wasn't really thought of a while ago because most indexes did not have fast-track entry and it wasn't an issue for determining the style categorization when a company was launched.
So it's really like a knock-on effect of these potential fast-track IPO inclusion rules. If companies are at it after they've been already seasoned a bit, there's less chance that they'll be incorrectly categorized, or at least they'll be using the existing index methodology rules in order to categorize them the way the indexes think they should be catalogized.
So in general, I think investors have moved to broader benchmarks and that has helped. So if you're an investor in a broad benchmark, you're not concerned about a shift from growth to value or vice versa. Same with the proper sector. If you own the whole market, you don't really care if it's going to be in communications or industrials, you own the whole market. But obviously the indexing world has grown so large and so complex that there are many, many investors using styles, using the different sectors for many different reasons. So for sure this is a topic that needs to be addressed before we get to the point where a name might be added completely into value and then at the next rebalance, it flips completely into growth. So definitely something that index providers need to be thinking about as well.
Peter Haynes:
I was speaking to a fundamental investor the other day. In the case of SpaceX, it's the most widely held private company in history. It is so widely held amongst the institutional, traditional institutional community as a private security held in public funds. And right now it will be sitting in growth funds. And so it's an out of benchmark bet for those active managers. And now not only will it become an out of benchmark bet, it'll become an out of style bet for them. If you're a large cap growth manager and you have Russell One as your growth benchmark and all of a sudden SpaceX ends up on the value side for Russell 1000. It just doesn't make a lot of sense. It's literally the other side of the organization, completely different portfolio managers. And meanwhile, I think everyone in the world would think this name is a growth stock. So that sort of test for reasonableness tells us something needs to change there. We'll see if it does.
So I don't want to just spend all our time here on SpaceX, Jeremy. There are some other significant events that are happening and they're just on the horizon here and I'm going to start with what is turning out to be a really big MSCI rebalance at the end of May. Can you explain why this event is so material?
Jeremy Lai:
Yeah. So this coming May rebalance for MSCI is projected to be the largest ever should be over 160 billion US in two-way gross turnover across the world, much of which, if not the most of it, coming from a methodology change that is finally being affected this May in that they are revamping how they calculate float for various companies in particular how they round the float, which MSCI and S&P do. I believe FOTSI does not. But MSCI currently rounds the float for companies in their global benchmarks. They round upwards to the nearest 5%. So if you are a 96% float factor on paper, in reality, you would round up to a full float. What they are now doing is instead of rounding up to nearest 5%, you will round to the nearest 2.5%.
The effect of that just mathematically is, first, because previously or currently in the methodology, the benchmark results in all us equal companies are more often just rounded up because there's no way to be rounded down. Unwinding that is supply and a float decrease on average for stocks. And then you have the effect of rounding to nearest 2.5%, which can kind of go in either direction.
So the results of affecting this methodology change globally is over $60 billion of float decrease flow notionally on paper, which then results in a equal or similar sized reinvestment trade across the global benchmark. And that's how you get to amongst also with regular sort of flow changes, share changes and as the leads migrations, what have you, 160-plus billion USD on the global trade.
And so the event not only obviously being the largest notionally in turnover of course is resulting in one where the amount of liquidity that needs to be provided into is not a record, but the global trade is also not very uniform because certain regions are experiencing much more flow decreasing activity from the methodology change. And then as a result, other regions are then a much more significant benefactor of the reinvestment trade. In particular, Japan is the largest single region in terms of total notional of float decreases resulting from this methodology change. But then as a total region, EU has a lot of countries that are experiencing large flow decreases.
On the flip side, the Americas, although notionally the US is the biggest market and so notionally has really big flow changes, they are not really as big in proportion to how large the US market is. And so as a result, when the dust settles for the reinvestment trade, you should see a global trade where APAC and EU is essentially going to be sellers of stock and then America's closes the 24-hour rebound day as a buyer stock mostly across the board, I believe outside of Mexico.
Peter Haynes:
Yeah, except for NVIDIA and a few others. NVIDIA is the largest name in the world that has an adjustment simply because it's moving down from wherever it is exactly to the nearest 5%. And another interesting aspect of that, Jeremy, is that I believe we calculated $12 billion worth of NVIDIA needed to be sold as part of the indexer weighting reduction. But interestingly enough, when you take the global trade and put it all back to work, three billion of that global trade goes back into NVIDIA and it nets out at nine. So this is one of those confusing situations where awaiting decrease on a name doesn't mean that name is for sale because the reinvestment trade might be bigger. We've seen that a few times.
Jeremy Lai:
You get the effect where every flow decrease on paper is going to be a smaller decrease than it would be in isolation because the reinvestment is going to the entire globe. And then in particular, if you are a name that has no flow decrease on the back of this, you are going to be in demand again as a benefactor of the global reinvestment trade.
Peter Haynes:
Just confirming again, the date is May 29th at the close for this MSCI, the end of the month, right?
Jeremy Lai:
May 29th except for I believe Saudi Arabia, which is on May 21st.
Peter Haynes:
Right. Check your holidays. There may be some countries that aren't open on that day. So it's the day that, we're going to talk about holidays in a second, but it's the day that's the last day before that date.
So Karl, we're talking about global markets, obviously some impact on global portfolios around MSCI, but there's another issue that's really become a highlight, a hot button issue in global markets and that is the fact that there are so many companies globally that are being drawn by the magnet of the US market and the size of the US market. And we'd like to say chasing the index rainbow, index benchmark rainbow.
UK investors are all too familiar with companies that have redomiciled in the last few years to the US in search of index inclusion and one of them was recently added to the S&P 500 and that is CRH. And in Canada, it's been a common refrain from Canadian issuers. We're constantly asking, what will it take to be eligible for the S&P 500 or US indices, even though these companies remain incorporated in Canada? So it's becoming more complicated over time to draw the lines on where a company belongs for domestic index purposes and yet domestic indices are also becoming less and less relevant as investing moves global.
Does your index team, your 25 portfolio managers that you oversee manage assets that are linked to global domestic benchmarks, say other than in the US and are you supportive of the potential for global names that have a big presence in the US are listed on the US market like some of the big Canadian interlisted names becoming eligible for the S&P 500?
Karl Schneider:
Yeah, we do have some non-US domestic benchmarks that we manage for folks. Over time though, we've definitely seen more of a trend of people moving to the more broad global benchmarks. And for global investors then non-US domestic benchmarks are definitely less relevant over time. I know there's definitely domestic investors in these countries for, this is still a gigantic issue, but for global investors, it's not as big of an issue.
It's a little concerning for sure that companies are in essence gaming the index inclusion rules in order to list in a market that can provide better access to investor capital. If you get index inclusion in Russell or S&P Five in the US, that automatically comes with a gigantic bump in demand for a company's shares. So it's understandable. That's a powerful draw and it's really not that hard for a company to tweak some of the index inclusion rules in order to make something like that happen. It's not like they have to completely up and move their operations to a different country or move it to the US in order to make this happen. They can change their headquarters or put a listing somewhere else and sometimes it's a fairly quick thing for them to do.
So index providers, they've been working on and refining their domicile rules for years. I don't think there's a perfect solution. You can't always stop these types of things. Companies are pretty innovative when it comes to trying to game things and make whatever's best for them.
Certainly if you think about extrapolating this further, what does this mean for domestic indexes in Canada or the UK that you were talking about? It seems like the relevance is going to continue to decline unless there's some kind of a solution proposed where there's either that can be represented in multiple index, multiple countries or some other rule changes that can come into effect that can stop this from continuing.
Peter Haynes:
Well, that comes back to that, again, within that 27-year window, you'll remember when the Canadian and Dutch names were taken out of the S&P 500 in 2002 and here we are almost 25 years later, both of us still in the same chair as we were in then and still thinking that, "Well, maybe it makes sense now to make these names eligible again." And so it'll be interesting to see whether or not that happens as these names are all global and they're very widely traded in the US market as well as being important in Canada. So big challenge.
So Jeremy, on the topic of domestic Canadian indices, S&P has been running the benchmarks in Canada for almost 30 years. And I would say personally, having lived through that period, I think they've done a great job caring about local Canadian conventions that are important to Canadian index followers. I would be remiss if I didn't shut out David Blitzer who chaired the Canadian index committee along with the S&P US committee and really did care about listening to the users here in Canada and his team have done a good job since he retired a few years ago.
Now that said, there was a hiccup recently where a company, a Canadian incorporated company, Ritchie Brothers, was deleted from the Canadian indices after a merger with a US company. And this led to a new rule that allowed Ritchie Brothers back into the Canadian S&P TSX comps index while still being US index eligible.
Now later this year, a large cap Canadian name, Tech Resources, will merge with Anglo-American, which is UK and the resulting company will be a UK incorporated company and that will mean tech will be removed from the Canadian indices when the deal closes. Interestingly, Canadian active fund managers who arguably today are more important and more relevant to the comps index have raised a lot of concerns about losing tech from the S&P TSX benchmarks and they're pushing S&P to find a solution to keep it in the Canadian indices. S&P made a proposal, which they're calling the straw man, I guess, and it's been circulated on their website. They've been meeting people one-on-one and this is a solution to deal with exactly the tech Anglo style merger.
Tell our listeners, what is that proposal that they've made and what would you do if you were S&P?
Jeremy Lai:
So at a high level, the proposal without stating the exact minutia is that if a company is TSX listed and also passes all the existing S&P TSX comps tests or what have you like size and liquidity, then it would be eligible for the benchmark.
I think that this proposal in its current form is generally frowned upon, generally disliked by the community. I think that the spirit of what they're trying to accomplish is very valid and valiant, but in its initial proposal, definitely the sort of hammer, sledgehammer approach that I think needs a lot of refining before anyone can really feel comfortable with this.
I think some of the potential implications you could easily have any company then deciding to list on the TSX with the purpose of potentially getting added to Canadian indices, ones that are entirely not representative of the Canadian market, especially if they are the types of companies that must definitely have to be large, but many US companies are well and enough large enough to be passing Canadian hurdles. But then also just the type of company that turns overs float often enough, which is likely something that's more retail driven or tech heavy or what have you, could easily pass those existing hurdles and would just need to list on the TSX to get into the Canadian benchmarks. Definitely not the intended consequence, I would think, to have something like Nvidia then represent over half of the Canadian market.
So I think it leaves then a lot of questions as to where do we go from here. I think that again, it's a very valiant endeavor to try to have the Canadian benchmarks have higher breadth and have a mechanism for maintaining certain companies that have a certain Canadian presence or are felt to be important to the Canadian economy to remain in Canadian benchmarks despite say M&A activity or other corporate action activity that may result in say by the current rules, a removal from Canadian benchmarks. What I don't like is not having tangible rules that can be quantitatively determined for placing those companies in the Canadian benchmark.
Essentially, I think that giving S&P full discretion to decide what companies are Canadian or not is not the way to go. It's I think broadly thought of that, I can't speak for everyone, but I think it's a strong feeling that S&P currently has too much discretion in a lot of the decisions revolving say 500 changes or 60 changes. And even then, even for 500 changes, which sometimes feel like you just put your finger in the air and the change happens or doesn't happen, there are actual guidelines that S&P is working around, like minimum sizes that are basically being passed by like 30 names in the pool. But then also other thoughts like they need to balance sector representation, they need to consider companies and the stability of their size and obviously size itself if you're larger, you're more likely generally to be added.
So all of those core tenants, some of them very explicitly actually define in the methodology even though you can't just use those guidelines to then get to what decision they're going to come up with. I think it's going to be very important for S&P to come up with similar guidelines when they make domicile decisions and keep companies in Canada, which is a structure that is pretty similar to how CRISP currently approaches some of these decisions. They're not acquired by Morningstar, but they have a committee where if a company it's incorporation and headquarters don't match as US, they go to essentially a test, a couple other things also that need to pass, but they essentially go to a test where the committee meets and has discretion to decide whether those companies are eligible for their US benchmarks.
And in the guidelines for that test, they put out various data points that they look at like foreign issuer status like assets and revenues for representation, do they file 10Ks or other US filings? And so you can't necessarily kind of quantitatively throw those all together and say, yes, for sure it's US, but it's important to have those guidelines in place so we can have some semblance of control over how these decisions are made.
Peter Haynes:
I agree there has to be some qualitative factors in there. I totally agree with your thought process there and I'm sure S&P will continue to refine their proposal. Clock's ticking though. This tech deal could close sometime in the near future so we have to pay attention.
Now, Karl, I did say we were done with mega-caps, but it is worth mentioning that the upcoming IPO, SpaceX, which is expected to occur in the second half of June and its index inclusion, which will happen either 5 to 15 days later, adds to an already very busy time for index managers like yourself and your team. You have the regular June rebalance for the FTSE GEIS and S&P on the third Friday of June, although that date will be Thursday in this June. You have the annual Russell rebalance on the fourth Friday and then you're going to have potentially a mega-cap index edition happening around quarter end. You're going to have it potentially happening for different benchmarks around the July 4th holiday and it's just going to be crazy. In fact, you might have some of those events overlapping with the regular rebalances.
Are you worried that any of these index events and index events in general are just becoming too big for the market to handle? And what do you think of the decision that S&P made that they will actually do the Canadian rebalance for the Canadian benchmarks on the US holiday, June 19th, Juneteenth. Juneteenth when the US market is closed?
Karl Schneider:
Yeah. So June certainly is shaping up to be a busy month. From a pure liquidity of rebalance names perspective, no, not really concerned that these index events are becoming too big for the market to handle. The number of participants in the marketplace trading index events has grown so significantly over time. It's obviously not just long only indexers out there. We've heard a number of different anecdotal examples of the number of hedge fund pods that are out there trading index events. And lots of times you hear stories of competing pods at the same firm going against each other and trying to battle each other for supremacy and to try to put the others out of business in a sense.
So this increased activity of the pods, they're not just trading a week ahead of an index event. Oftentimes they're in there months and months ahead of an event and it's not static. They're coming in, they're going out. It's really dynamic and fluid what they're doing. I don't really worry about the liquidity of these big events because of this increase in activity from so many different market participants.
Now as ETF AUMs continue to grow, the need for broker capital sometimes to facilitate custom basket trading, now that's potentially something that we need to keep an eye on as these index events get really large and as the index AUM continues to grow. So the resources from a capital perspective at our counterparties is not unlimited. So when you have all of these events happening at the same time, each individual one might not be all that big of an ask, but when you have some that are layered on top of others, then all of a sudden the demand for capital might be pretty significant for some of the counterparties. So that's something we're definitely keeping our eye on and making sure that we can give as much heads up in advance as we can for these events.
And we did see MSCI and Russell move in recent years to spread out the impact of their main rebalances. So MSCI moved to quarterly rebalances and Russell's now moving to semi-annual rebalances. In theory, this makes a ton of sense, spreading the liquidity over time and arguably getting better representation of the market through this way. If it results in increased turnover though, we're generally not in favor of these more frequent rebalances. And I think Russell recognized that with their style indexes and that they kept those on an annual cadence instead of moving those to semi-annual as well.
You mentioned Juneteenth. And so specifically for Juneteenth, I think it makes sense for index providers to line up a rebalance stage which does not have a large percentage of an index on holiday. So we've seen other index providers move and align rebalance dates to ensure that they're less impactful. It makes complete sense to me to move all of the related quarterly rebalances to the Thursday before Juneteenth. I mean, if Canada trading on a separate day from where a lot of the liquidity is does not seem to make sense, and I think the precedence there from other index vendors that if you see a giant percentage of the world on holiday move that rebalance date to a time that works for everybody, wouldn't have been that hard of a lift for them to just move everything to the Thursday. But they decided to kind of stick with apparently the rules around their holidays when they came up with that schedule.
Peter Haynes:
I spoke at a conference earlier this week where one of my peers from Canada said that was a good decision showing we have some sovereignty in this country and don't have to be totally aligned all the time. I completely disagreed.
Jeremy, how important is it? What do you think is going to happen on June 19th when we don't have a US market and we have rebalancing activity in Canada?
Jeremy Lai:
It's definitely a challenge and I think anyone that has traded Canada extensively knows that you cannot trade the Canadian market without consideration of the US market liquidity. There are tons and tons of names, many of which are our large caps, one of which is even a top three company, which trades multiples more in the US day by day than the Canadian market. Shopify, our number three company, many days will trade 5X more volume in the US than Canada and the Canadian market quote is entirely just pegging the US market quote and being a little bit wider and that's how price discovery happens. It's just movements in the US market, liquidity in the US market and the Canadian market is just a wider version of the US one. There are other stocks that are 10X more liquidity or volume in the US compared to Canada.
So what ends up happening is that when the US market is closed, the Canadian liquidity essentially will just entirely dry up without that benefit. And when you head into some of these rebalances where some of the lower ADV, the higher notional flows like the flow changes and what have you are rolling through the market, reality is that most of those flows are not 100% offset by the hedge fund community that has prepositioned for them. These are the lower ADV ones that are not headline changes like Azure [inaudible 00:54:52]. They show up in the close the right way for like five or 10% ADV and the continuous market liquidity is what is recycled back into the close to create an orderly closing price. And that continuous market liquidity depends, it crucially depends on the US market liquidity for a stock that predominantly trades in the US so that people can trade in advance in the US and then take that and put it into the Canadian MOC.
When that is absent and you have a regular sort of 10% ADV flow, let's say in Shopify or Denison Mines or anything else that trades predominantly in the US, you magnify the reality of that liquidity demand in terms of the market's ability to absorb it. And so you can get very, very outsized sort of closing movement into the Canadian close that you wouldn't necessarily experience otherwise.
Peter Haynes:
Jeremy, I don't honestly think we're fear-mongering. I am worried about this. The first time in history that the Canadian rebalancing quarterly rebalance will happen on a different day than the US with the markets being so intertwined. And the Canadian reliance on the US being as big as it is, I'm concerned and it'll be a busy period as Karl mentioned a second ago.
Jeremy, I got the final question for you. The institutional community's constantly bemoaning the fact that liquidity is harder to find and expectations are it's only going to get worse when you have tokenization and trading of equity like exposure on decentralized finance platforms. And then we also have 24 hour trading coming. Meanwhile, the closing auction remains the one point each day where there is a ton of natural buying and selling and that's often driven by index related flows. What advice do you give to fundamental investors who want to take advantage of these index liquidity events like safe SpaceX's index inclusion?
Jeremy Lai:
The old adage remains true that flow begets flow and these events being so large, the close continuing to grow and some of these concentrated demand events across index rebalances just continue to become larger as we continue to mature as a market. And so the close its relevance is not waning. It's just continuing to grow. And so when you are looking for, especially for the ability to trade flows with limited market impacts, it's tough to not be there where the flow and volumes are. And so it's imperative to be really considering, continue to put liquidity and activity closer to the closing auctions.
Peter Haynes:
We don't always se imbalances going in the same direction as an index ad, but yet there could still be net demand. It just shows up in different ways. In terms of the types of orders that you suggest fundamental investors that might have large positions on their pads that could have some flexibility on when to trade using limit orders to offset imbalances, using putting limit orders in continuous books, how do you suggest fund managers play these changes?
Jeremy Lai:
It becomes a sort of workflow issue and being able to consume data, because the close happens so fast. You have 10 minutes to see imbalances to react to them. They're changing every 10 seconds as a new imbalance is published. You hit the freeze period by six minutes in. So it's-
Peter Haynes:
Canada. Canada, to be specific. Canada.
Jeremy Lai:
Canada, yeah. But NASDAQ's even worse. NASDAQ, you hit the freeze in five minutes. So it's imperative to have technology that allows you to consume all of that data. Of course, if it's something on your pad and you're staring at 10 names, you can easily check what the imbalances are for those specific data points, but working with broker data that's screening for large situations, difficult for you to then react in the last 10 minutes to go to a PM and grab a new order, but to be ready heading into the close just in case I think is kind of the workflow going forward.
Peter Haynes:
Well, we covered a lot of ground here in an hour on index issues.
Karl, I can't thank you enough for coming on and helping to educate our listeners what it's like to actually sit in the index nerd PM room and then have to talk to index nerds like Jeremy and me on a ... Well, you don't have to, but you're kind enough that you do speak to us from time to time, but also speaking to our audience today about what are becoming increasingly important and complicated events. So thank you for joining us, Karl, to my colleague Jeremy for joining today. This was a great discussion. And good luck, Karl, over the next month for you and your trading team. It'll be a busy period. I'm hoping that once the dust settles a little bit, you'll be able to enjoy your summer. So thank you to you for coming on.
Karl Schneider:
My pleasure, Peter and Jeremy. Thanks for having me.
Jeremy Lai:
Thanks, Peter.