The Myriad of Index Issues Affecting Global and Domestic Benchmarks

PETER HAYNES: Welcome to TD Cowen's podcast series, Bid Out, a market structure perspective from North of 49. My name is Peter Haynes. And today, for episode 67, we check in on a panel held at our recent 25th annual Portfolio Management and Market Structure conference. As has become tradition at this event, we invite executives from each of the major index providers-- MSCI, FTSE Russell, and S&P Dow Jones-- to participate in a roundtable discussion on the key issues that are impacting the index benchmark landscape currently.
For this year's panel, we added an index fund manager to the discussion, Mike Perry, a portfolio manager with the international team at Vanguard. Topics we covered in this discussion include recent consultations on domicile-- a topic near and dear to Canadians-- and on single-name concentration, l South Korea's status as a split country, and the possibility it moves either to a merging for FTSE or develop for MSCI, and accountability for index provider errors that leave a footprint in the market.
The panelists also discuss the complex question of whether indexing is a crowded trade. Other participants on this panel include Catherine Yoshimoto from FTSE, Jean-Maurice Ladure from MSCI, and Louis Bellucci from S&P. I hope you enjoy this discussion as much as I did.
We're going to get started on our next session here entitled Index Potpourri for 200, digging in on the myriad of index issues affecting global and domestic benchmarks. Joining us here today on my far left, Mike Perry, who is a portfolio manager with Vanguard. Thanks for coming, Mike. Beside Mike is Catherine Yoshimoto, who's head of equity product at FTSE Russell in the Americas.
In the middle is Jean-Maurice Ladure, JML for today, managing director of global head of index management research at MSCI. And to my immediate left is Louis Bellucci, who's back again ll year. And again, thanks to S&P for always making their executives available to be part of our discussions here. Louis is head of committee management and index governance for S&P Dow Jones. So again, thank you to all of you for joining us.
So as I said, I was giving Rob the first question. And the first question was we're in this direction with respect to indexed assets, and what if we ever run to the other direction and the question of who's the buyer? Mike, why don't I actually-- given that you're the one portfolio manager up here, why don't I have you think about that question from your perspective as a PM at Vanguard.
MIKE PERRY: Sure. Let me talk about the benefits of indexing. I think for us, we think costs matter. So when you line up funds and their expense ratios from one to whatever number there are, the highest quartile costs are in the lowest quartile of performance. And you can guess which quartile has the best performances. It's the low-cost funds. We're proponents of total market indexes.
So like Mr. Arnott said, we don't have to worry about Tesla being added to an index because it's already part of the index from the start. The total stock market fund that we have has 4,000 securities. And a company like Tesla can grow. And the implementation costs that were mentioned just doesn't happen. For every $10,000 that's invested, we charge $3 to manage the assets. So costs matter.
It's not just about expense ratio, it's about turnover. So a fund like that has only 10% turnover annually, where most active funds are somewhere north of 100%. Trading is a subtractor to value. So the less trading, the better. We agree there's some index changes. We don't always go 100% on the close. We manage the implementation of those changes. We work with our index providers in terms of managing the implementation of those changes.
So for example, when Saudi Arabia entered the index, the index committees worked with the index providers in terms of implementing a tranched approach so that we wouldn't have that cattle chute effect of everyone heading for the door at the same time. So we're very sensitive about costs and trading costs. The other thing is tax efficiency. So if you own everything, you're going to have a more tax-efficient product. Those are the things that we look at in managing funds.
PETER HAYNES: So, Lou, the second part of Rob's question had to do with the manner with which index changes take place. I think if I'm parsing, Tesla is a great example. And S&P considered doing a tranched approach to including Tesla, ultimately chose not to. I think the end result, we know from just the previous conversation, was a fairly parabolic increase in the stock. As you've sat in the chair you sit in for a long time and think about is there a better way to do index changes to reduce the impact that Rob was talking about, how has that conversation gone with your users?
LOUIS BELLUCCI: Yeah, Tesla is, I think, the most extreme of examples of this. So it's a good one in that sense. But far and away, exchanges happen efficiently. With the Tesla example, the index committee made the decision to add Tesla at a certain point, but actually went out and conducted a market consultation on how to go about doing that, and checking on the feasibility of that, the efficiency of it. So it went out to the market. Anyone publicly could respond. And I think it actually set a record for the most responses we've ever gotten on a consultation.
In the end, you're right. We ended up implementing it in one go as we do normally, which speaks to some of that feedback saying that at this point in time, there's still that liquidity in the market. There's the efficiencies there. There's not much of a concern about doing this in one go versus maybe spreading it out among multiple days or quarters for that matter.
PETER HAYNES: The idea for-- or I'll ask JML for MSCI-- about CRSP, for instance, which is a benchmark that's followed by Vanguard and others, uses a five-day averaging for inclusion and removal and movement from different phases, or styles, and sizes of the benchmark. Has MSCI ever considered doing something or have you done-- other than maybe a free float adjustment where there's a big thing, but just on index changes, finding a different model using five day-- using VWAP, using five days of the close, something like that?
JEAN-MAURICE LADURE: Yeah, just a couple of points just to rebound on Mike's point. I think we should not forget that the objective of indices is really to capture the whole opportunity set. And hopefully, when you do it from the beginning, you don't necessarily need to have those big jumps of adding a new stock.
Stock can start as a small-cap transition and get bigger and bigger. As it happened on the MSCI indices, Tesla became a small cap in December 2010, became a standard constituent in August 2013. I wonder how many people in 2013 had already stock picked Tesla. Hopefully, some of you have.
But the benefit also of buying the whole market is allowing you to capture very early what could potentially become the mega cap of the future. Now, in term of the rebalancing, we actually had a consultation about this, about trying to stagger at that stage. And I'm sure things will evolve. But at that stage, in [INAUDIBLE] in practice for most of the market, it's very, very difficult. It's more, I will say, a technical constraint from the majority of our clients to really have to spread it across five days.
Now there are very sophisticated clients who can do this. And that's the kind of stuff where also we can put in place in custom indices solution when it's needed. But I think certainly, would be useful maybe in a few years' time to review because with all the progress we've seen, there may be more people now who will be able to have this staggering approach.
PETER HAYNES: So, Catherine, as I think of FTSE Russell and I think of the Russell in the US, one of the reasons why people follow the S&P 500 is ironic-- we're talking about trading costs-- is because the 500 names are investable. They're big. But with the case of the Russell 3000, when a stock gets added to the 2000, not only is it typically a small cap name. The size of indexed assets linked to the small cap index in this instance is much higher than it is to the large-cap benchmark.
So not only are people-- or if you're an R2 investor, are you buying what is deemed to be a less-liquid stock. The size of the index funds managed linked to that benchmark are so high. So have you thought even for something like R2, a different-- I recognize it's complicated in light of how Russell does their annual revision. But has there been any thought to, given the impact of R2 additions, changing the way that you manage rebalancings for R2?
CATHERINE YOSHIMOTO: Well, I think everyone's already mentioned some threads that are prevalent in the indexing industry, which is that the indexes must be representative. All of us have governance and policy processes around how the indexes are maintained and the rules are governed. In terms of the Russell Indexes, going back to 40 years ago when Russell consulting launched the Russell Indexes, the design was to solve a problem. Actually, at that time, the S&P 500 was primarily used by institutional investors.
Wilshire 5000 existed. However, most of the stocks were considered illiquid. Dow Jones obviously existed too, but then it's a price-weighted index. So market cap weighting was very important in terms of representing the markets. And the construction of the Russell 3000 was based on investable stocks, based on the Russell consulting clients' portfolios.
And so that's how the 3000 stocks were identified in large cap, was determined to be actually what large-cap managers were managing against, not just the S&P 500, but a broader group of stocks. And then the Russell 2000 was the smallest 2,000 companies in that Russell 3000.
Now, in terms of the inclusions, it's part of the objective and transparent construction of the Russell Indexes. Originally, the Russell Indexes were rebalanced quarterly. Then it went to semi-annual. And then it's been rebalanced annually, since 1989. We're actually consulting on whether to add back a reconstitution, bringing it back to semi-annual.
However, in order to offset some of the inclusions that might happen between the annual reconstitution in June, and since 2004, Russell Indexes have added IPOs on a quarterly basis. So Tesla's been brought up as an example. Russell Indexes added Tesla a quarter after it IPO'ed in 2010 to the Russell 1000 index.
Now, going back to your question about the Russell 2000, all of this is part of the broad construction and objective rules that are used to determine membership in these indexes. And there's also a lot of academic research around-- you mentioned the assets tracking the Russell 2000. Certainly, some stocks may be less liquid than others, but index inclusion does bring long-term asset flows and institutional investor money.
So even when a stock might be deleted from the Russell Indexes, let's say, the institutional money might stay with that stock and just bringing liquidity overall to the markets. So this is beneficial to investors, in general, because it brings opportunity and diversification to the markets.
PETER HAYNES: So let me just follow up your consultation on whether to move to a semi-annual rebalancing. I'm curious what the feedback was that you got. And then I'll ask you, Mike, whether you guys support going to semi-annual for Russell.
CATHERINE YOSHIMOTO: We have not announced a decision yet. The target is to announce by the end of this year. I can't share much of the feedback yet. However, broadly, there are both sides to-- with every consultation, there are both sides to the argument.
PETER HAYNES: And, Mike, what was your side?
MIKE PERRY: You know what? Our primary objective is to reduce costs for our investors. So if it means going to more rebalances, we're going to do it.
PETER HAYNES: Do you think that's better for them to have the single event in June?
MIKE PERRY: Absolutely.
PETER HAYNES: But as you say, Catherine, there was mixed responses. Was it mixed amongst the type of investor that Mike is? Because we know Vanguard was in favor of it. But generally speaking, would the large-index community be in favor of this, or was that a mixed response?
CATHERINE YOSHIMOTO: Generally, we believe they're-- either decision might be supportive. But generally speaking, if we do decide to go, it will be supported as Mike indicates that we do believe that this could be viewed as a positive move.
PETER HAYNES: And so you're saying, mn year end, you think you'll have an announcement on that? No, I think you said that. Is that right, virtually? OK.
CATHERINE YOSHIMOTO: That's the target.
PETER HAYNES: Consultations is something we'll talk a lot about here in the course of the next half hour. So we'll get to the actual questions that we had in advance here. But thanks, Rob, for stimulating that debate. I'm going to start with you, Lou. And I'm going to talk about the front burner issue in Canada, which is going to be discussed throughout the day, which is the future of our capital markets, but more specifically for this discussion, the future of our local benchmark.
So we've seen this gravitational pull of capital around the globe to the US. The UK has seen it with a lot of its large-cap issuers redomiciling, leaving the FTSE LSE to go to the US in search of what I will call the pot of gold of index buying at the end of the rainbow. So it's no secret that inclusion in US benchmarks, as Catherine just mentioned, results in a lot of index buying.
And there's more indexers in the US tied to the various US benchmarks. So if that's a goal, then obviously it's going to be good for issuers. In Canada, we've seen this impact a couple of ways, not so much on redomiciling but we haven't had any IPOs-- one IPO over $100 million in the last two years. So our firm system is disappearing.
And we have these duly listed large-cap names that are looking for ways to strategically structure themselves to get in more benchmarks. Brookfield Asset Management is a perfect example of a company that recently moved its headquarters to the US. And that was done solely so that they can be included in FTSE-- excuse me, Russell in the US, Russell 1 and CRSP. And I don't think Brookfield Asset Management would hide the fact that index inclusion was the goal of that decision.
Back in 2023, S&P made the decision to move Ritchie Brothers to the US. That was a Canadian name. And we were surprised by that because incorporation, we thought, was the benchmark that mattered most. What has been the industry feedback that you've received so far on this issue of where a company should be located for domicile? And what are you doing to address the issue?
LOUIS BELLUCCI: Yeah, it's true. This is a global trend. And it's an increasing occurrence that companies around the globe are looking for how they might become eligible for US indices. And there's nowhere that that's more topical than right here in Canada, as you said.
In light of that, S&P has had many, many conversations over the past year plus, really following that Ritchie Brothers RBA change on our domicile policy. Issuers are looking at our domicile policy and saying, hey, if we change this or this, does that get us in? So we've been looking for that and trying to bolster our policy. The feedback has really varied and really across different types of index users, stakeholders in the market, the issuers themselves.
But I think there's a few themes that I could probably highlight out of those conversations. The first one is an ask for a clearer and less ambiguous domicile policy, something that's more black and white. I'll give you an example of that. In our policy, we use primary listing as one of the factors in determining domicile. So what is primary? What does that mean? Is that where the company listed first? Is that company history? Is that investor perception? Is that simply what the company says? Or maybe it's a liquidity test.
I think it's fair to argue that it's just as relevant when determining where a company is anchored or domiciled, that they maintain a listing and maybe a smaller or less liquid market, as well as maybe in something like the US, where you're going to see more liquidity naturally. So that would be one.
Two is incorporation. You mentioned it. There are several factors that go into determining a domicile. A common piece of feedback is that incorporation should be a standout among those factors. From an index perspective, I think there's a few benefits to that.
One, going back to that being unambiguous, it is black and white. It's either A or B. There is no question mark around it. Two is that it's sticky, meaning that it's fairly difficult to change. It's an investment. It's somewhat costly to do so for issuers. So it adds a bit of stability or continuity to our domicile assignments over time.
The third feedback, which I think is interesting compared to the first two, which is about transparency and ambiguity, is that as these conversations carry out-- there is a realization as occurred at I think our Canadian advisory panel a couple of weeks ago, is that there is some value to an index committee overseeing these domicile assignments and being able to look at these on a case-by-case basis.
So with all of that said, we went out and we conducted a consultation over the last six weeks. It closed at the end of October. The results of which are not announced but should be before the end of this month is what we said. I won't go into the details of everything that was proposed there. But there is, I think, one piece of information I want to focus on, which is some of the data we provided.
S&P uses a three-pronged primary factor approach-- incorporation, listing, primary listing right now-- as well as operational headquarters in determining domiciles. 90% of companies in our equity universe, those three factors match. It's a very simple domicile assignment. Another 6% of those are domicile of convenience, which leaves just 4% behind where there is a mismatch. Those are the outliers, the exceptions, the edge cases.
And the reality is that when assigning domiciles for these 4%, it's complicated. And that's where I think, circling back to the point number three, it's important that there's an index committee overseeing that to make sure that there's not gaming happening by issuers and that the index committee can ensure that domicile assignments remain most representative of where that company is tied, anchored, and so on.
Very last point I'll make is that just alongside this, I think there's a growing interest in creating index-specific rules for certain domestic benchmarks such as the S&P/TSX Composite or 60, that are different or separate from the global policy that S&P has on domiciles. That could result in overlap between country benchmarks such as Canada and the US.
But generally speaking, I think that that would or could help to protect the robustness of the S&P/TSX indices. And also, that overlap seems to be not much of a concern because the users of each of those indices tends to be a bit different. So the issue of there being overlap really is a kind of minority of the market.
PETER HAYNES: It's a very, very interesting question, we'll get to it a little bit later, about whether or not companies should be in more than one domestic benchmark. Just on the theme of domicile, JML, MSCI and S&P are partners on GIC classifications. I'm curious. Is there any way we can negotiate a way where you guys can become partners on country classifications so that we don't have to go through this as much?
And secondarily, how do you guys look at country classification compared to-- I know all three of the major providers have different rules. But do you consider it a point of differentiation, something that your users come to you rather than the competitors because of the way you look at that?
JEAN-MAURICE LADURE: Yeah. I mean, it's a very important point, especially for us with our global benchmark. MSCI ACWI, MSCI World, MSCI EM-- you've got a lot of country to choose from. And we consulted a little while ago. And the feedback we got from clients was try to keep it simple. And if you go too perfectionist, then it will create some problems also for us in terms of investment process.
So it feels very nicely with our overarching approach of building blocks. No gaps, no overlaps. Each market goes into either in MGM or frontier market, and each security is going into just one country. So in term of classification, very simple.
Like Louis was mentioning, the vast majority, you have a good consensus. We're only looking at country of incorporation and a primary listing. If they match, you're done. Next. Then, yes, you've got some which you haven't got this ideal match. And then we need to go in a bit more details about the geographic location of operation revenues and assets, the structure of the management, and the headquarters.
But I will say, yes, I think for us it's in our DNA, especially when we consider that, let's try to create a standard for investors. Because I think that's the most useful for the market. We did very well. I think we've been very successful with the GICS sector classification. So who knows? We're definitely not closing the door for-- potentially see if something can be done in partnership with other index providers.
Now my last point I would like to mention, and I think Louis was also alluding to, is those are our flagship indices. But for clients who have a more precise investment strategy, we have, for example, economic exposure indices where you forget about the country of classification. You really look at where the revenues are coming from. You can create custom indices where you pick up all the stock, which are one way or another, are connected to a special country. So all those things are also available, but then it's becoming custom.
PETER HAYNES: So, Mike, that actually leads to this sort of-- when I think about the environmental difference between 2000 and 2024. And one of those major differences is that companies that are part of large cap domestic benchmarks around the world are almost all global companies. And so you wonder sometimes. Why do we consider Shopify, which is now, unfortunately, the second largest company in the Canadian market ahead of TD as of yesterday, unfortunately-- by the way, I'm not upset about that.
So you look at a company like Shopify, which has 5% of its revenue in Canada, yet it's the second biggest company in our benchmark. Or you think of a name like BP in the UK, and 5% of its revenue comes from the UK. So we get into some of these different topics. And I'm curious of your thoughts, Mike. Number one, the idea that Barrick could be in both the Canadian index and the US domestic benchmark, or TD Bank could be 50% Canadian and 50% US. Because that's the asset breakdown, and it's big in both capital markets. Do you see us going in that direction in the world, either of those things?
MIKE PERRY: So one of the first primary things that we like is simplicity. So to have companies represented in multiple benchmarks, number one, would be operationally difficult. Number two, the thing is if that percentage of revenue changed, it would potentially cause turnover, which increases costs. So if you have a global portfolio, it really doesn't matter what country something is represented in.
Now, we certainly recognize that certain countries are going to have country-specific needs. And in that case, we think certainly headquarters isn't a great indication of where a company really should be represented. Or incorporation, we're on board with that being one of the primary things that's considered.
Even listings. I look at a company like Prada. Prada is listed in Hong Kong, but its headquarters are in Italy. The board is in Italy. It's incorporated in Italy. Why is listing the determining factor?
PETER HAYNES: Where is it from a country-classification standpoint?
MIKE PERRY: It's in Hong Kong.
PETER HAYNES: Is it? OK. For everyone or for all the major global folks? Because it's listed there.
MIKE PERRY: Yeah. And this is something-- it's an issue that I think all of the index providers and people in the industry need to come up with some best practices.
PETER HAYNES: So on that same vein, Catherine, the UK-- I mentioned earlier there's been a lot of leakage to the US market, domicile changes-- CRH, Ferguson, Smurfit, RMI appealing in the US, and the FTSE. Certainly, the folks at the LSE and the government have taken a lot of steps to try to stem some of the bleeding of companies leaving the UK market. And one of the things the LSE did was to merge together its two primary or two standards for listings, the primary and the standard classification. And we're into this period here of transition for certain companies. But at the end of the day, that changes how you look at companies for the FTSE.
I'm curious. Have you contemplated a scenario-- first of all, what impact does that have on the FTSE? And second of all, have you contemplated a scenario where Shell-- it's one thing for it to be CRH or Smurfit leaving to go to the US. But Shell is the second biggest company in the FTSE, and they have mused about going to the US.
How do you think you would react to that decision? Is that something where you might say, oh-oh, this company is still relevant here, and we're going to keep it in the FTSE and then let the US index providers make their own determinations down the road?
CATHERINE YOSHIMOTO: Well, all of us have transparent rules on determining nationality, as the other index providers have mentioned. So really, how we work with our committees, the external committees for FTSE Russell, is we would consult with them and for them to provide feedback. Now, the final decision is made by FTSE Russell, our index governance board.
However, if this is an issue-- again, I mentioned a consultation we've done, and others have mentioned consultations they've done so. So it really does go back to we would consult with our members of the committees for feedback into the methodology. It's not a committee where certain companies get voted into an index or not. It's about the high-level rules because it needs to be transparent and simple, as Mike mentioned. Simplicity is objective.
And really, I think that's what was behind the UK rule update in terms of trying to simplify and streamline the structure. And from there, we would continue to get feedback from our committees. And if that goes into consultation and further decision, that's how our governance process would work.
PETER HAYNES: And so just in terms of the merger, it doesn't have a lot of impact today. But I think the merger of the two classifications, what they were trying to do is just-- I think, for instance, multi-voting classes of shares weren't allowed to be on the primary. But now that they-- you can be eligible for the FTSE if you're either a primary or standard. New listings that come in and have maybe multi-voting are able to be eligible for the FTSE, I think. Does that make sense that that's one of the key differences in what the LSE has done on their listing standards?
CATHERINE YOSHIMOTO: There's the listing aspect, but there's still index eligibility rules, which is another layer. So FTSE Russell, we, I believe, were the only index provider left that has voting rights. So company voting rights is a criteria.
PETER HAYNES: That's right. I should ask you about that. But I've asked it for about 10 straight years on that topic, so I'm trying to move on from that debate.
CATHERINE YOSHIMOTO: But it is viewed as really critical in terms of investability. And going back to the innovation around the Russell Indexes, float adjustment even was a Russell innovation. Because they felt that the available shares to investors was an important part of determining the stock's weight in the index. And so on top of float, we apply voting rights. And that helps ensure that the stocks included in the index and the weight reflects the investability.
PETER HAYNES: OK, Mike, I got one for you. In March of this year, S&P published some changes to what is known as the Dow Jones 100 Dividend Index. And there's a very large ETF linked to that by one of the US brokers. The changes that came out from S&P Dow Jones on a Friday night were not what TheStreet anticipated, very transparent rules for this benchmark. So people could see in advance what they thought was going to happen based on the rules.
And so a couple of days of pressure from the industry, I think, on S&P to say, I think you got this one wrong. A couple of days later, S&P came out and announced that they were changing the list to something that looked a lot more like what TheStreet had anticipated. Meanwhile, the changes that weren't anticipated created a massive footprint in the market and then had to be reversed.
I think you could say, on the one hand, S&P got it right. And that's important ahead of the actual change. But the fact is, it's when the announcement is made that the impact occurs and the error is identified by TheStreet at that point in time. I think of all the index events that I've seen where there's been impact of any sort, this one got-- I got more vitriol from the traditional fundamental trading community on this mistake than anything else I've seen in my career, partly because of the size of the fund that was tracking it.
I'm curious. And it's not fair, by the way. I don't mean to pick just on Lou, because all the index providers have had issues along the way. I'm curious though, from your perspective, Mike, you've seen some errors along the way, I'm sure, in your role as a PM. What do you think should be done in these instances? Because we know there's going to be more errors in the future.
MIKE PERRY: Sure. First of all, the index providers rely on data providers. The fact is they're not good enough. So what we think is, there should be some local expertise that's brought in when needed. If there's a change over a certain threshold, there should be some local expertise brought into the picture to validate those changes.
Asia can be really tough in terms of float, so there should be local Asian experts in terms of what really is available in terms of float for these companies. We can do a better job there. We just saw something happen with FTSE this past quarterly where there was a name that was going to be added in Indonesia. And the night before, it was discovered that it was pretty close ownership and that didn't meet the investability rules, but it was too late to change. So it was added on the Friday, and it was deleted the following day.
Indexers don't always have to buy on the close. We didn't. We recognized that this was something that we could not buy, that it was within our risk budget in terms of tracking. And we made the decision not to buy it, and it was the right decision. Ultimately, the way we trade is to minimize cost for investors and give them the best chance for investment success. We are conscious of costs always.
PETER HAYNES: Would you say that you've seen an uptick in errors by the index providers overall-- I don't want to single anyone out-- in the past few years versus earlier in your career? Or is it just because they're more important now?
MIKE PERRY: I think there's more eyes on it now, definitely. I think the process has gotten better. We definitely have operational risk teams that visit our index providers, make sure that the processes are in place to provide accurate indexing. But there's going to be issues because some of the local nuances can't be captured all the time by these data providers. So there is another level of expertise that's needed locally to be brought into the process.
PETER HAYNES: Yeah. It is something I've noticed, I think, over time is that some of the index providers have outsourced that data work as opposed to doing it themselves and owning it internally. And I think that can be something that they-- and obviously, there can be some cost savings in that. But at the same time, you're now relying on third-party data providers that may not be as accurate or aware of the importance of that data.
Lou, it wouldn't be fair for me to talk about you, with you sitting beside me, without giving you a chance to respond. Is there a remediation process when you make an error like that? And do you have to contact the regulators? And is there any postmortem takeaways? And are you regulated is the question, because I know a lot of people think that the index providers should be regulated in some way.
LOUIS BELLUCCI: Yeah, I mean, let's start with that piece. The answer is in certain jurisdictions, yes. In the US, for example, where the product you mentioned is, the answer is no. The index providers are not regulated. Our legal team, SPDGI, keeps an open dialogue with the regulators, regardless. And we'll talk about all sort of relevant index matters. And that that might be incident, or it could include incidents from time to time. I don't know exactly with this one that you've mentioned. I wasn't involved in those conversations, so I'm not sure.
I really appreciated the mention of data. It's very relevant to this example. You look at an index with a universe of over 1,000 companies, it's a dividend-focused index with fundamental overlays to it. As you go through that universe and all of the different fundamentals that go into selecting that final basket of 100, you're looking at something like 20,000 individual data points. And each and every one of them can have an impact on that end result. So S&P is looking at ways to better multi-source those data points and master them so that we can avoid recurrence of similar issues, not only for that index, but across the 600,000-plus indices that we calculate.
Look, I'm sure that my peers have the same thing where there are lots of quality assurance steps in place to prevent that from occurring in the first place. The fact of the matter is that in this case, it did. When something like that occurs-- and that's any sort of incident, no matter how large or small-- S&P has a formal process to go through it, investigate root cause, and then implement any sort of remediation actions that might be appropriate or that we can find.
PETER HAYNES: It's an ongoing debate amongst the index users like Mike, about whether it's a good thing to have transparency in index rules so that-- and I don't want to use front running the wrong way-- so that people can anticipate the activities that are going to happen, position for that, and essentially dampen the impact on the event. Yet, some of the customized indices you manage that turned into very large ETFs, the individual fund manager might not want that information to be in the public domain, making it harder to replicate. Is that something you see that often?
LOUIS BELLUCCI: Yeah, at times. I mean, you're right. There's an ecosystem around these rebalances. And an important piece of that ecosystem is those with that risk appetite to act and trade during that pro forma period that you mentioned in your original question, Mike. This occurred during the pro forma period and was corrected before the index rebalancing actually occurred. It's a good balance, I think, between the different parts of the ecosystem there in finding and providing that liquidity to help those trades be implemented efficiently and cost effective. But at the same time, I think there's a benefit to them as well.
PETER HAYNES: Yeah. Look, a lot of the dealers have lost talent to the hedge fund pods. Those hedge fund pods are doing the same thing they did when they were working for a dealer is predict what's going to happen, just not necessarily publishing it.
So let's move on to JML. I want to talk about South Korea for a second because that's a controversial topic right now. It has a split status. What I mean by that is that MSCI treats South Korea as an emerging market, and FTSE considers South Korea a developed market. So I'm just curious. Why has MSCI treated South Korea as an emerging market historically?
JEAN-MAURICE LADURE: And let's be clear. We're not talking about South Korea as a country. We're really talking about the market. As a country, clearly it's a developed economy. No problem with this. As a market-- at MSCI, we have a very transparent market classification. There are three pillars.
Economic development, it's a tick for Korea. Size and liquidity, again, it's a tick. They have enough stocks, large enough, liquid enough, all good. But the third pillar is around market accessibility, and this is where it's deficient. And when you really want to enter the club of developed market, you need to be good on all three. It's very, very important.
So we consulted quite a while on South Korea. We actually started in '08 until '14. Every year, we were doing this. Since then, we stopped because actually it's still not there yet. And I think there are four main points, which are still not to the level you would expect for a developed market.
First is the current one, the currency. You cannot really trade it really properly offshore. That's the first problem. The second is the one-- the structure of the ID system. So in terms of the overall framework, it's still not as early as you would expect for a developed market. The third one is the availability of investment instrument for foreign investors. And the final one is actually kind of a new one from November last year, which is the fact that decided to implement a full ban on short selling. And again, that's not the kind of level you expect to enter the club of a developed market.
That said, they have announced some encouraging initiative. We're looking at this very closely with a lot of interest, could go in the right direction. But like always, before we go to concentration mode, we need the announcement. It's done. We need the implementation. It's in process. But the most important will be the testing. Is it working?
And that's why we will-- certainly at one point or another, we will go back to the market. There are new things being put in place. Is it working? Is it allowing you when you are a large international investor to access the market like any other developed market?
PETER HAYNES: It's interesting because government officials get involved in these discussions. We've seen that in China in the past, particularly with MSCI. And they're obviously wanting to be considered either developed, emerging, whatever it is. But it seems these countries can't help themselves. They stub their toes, whether they like it or not. And you gave a perfect example, JML, of how South Korea has stubbed their toe this year or a year ago, which was that full ban on short selling.
So, Catherine, I'm curious. When the government decided to ban short selling-- because all the other things that keep MSCI treating South Korea as emerging-- have clearly not been enough for FTSE to consider emerging because you've had it in developed. But now you have this new thing, which is a ban on short selling. When that ban was put in place, what feedback did you get from your advisors about whether that might have been the straw with respect to moving South Korea into emerging status, given that we need short selling to help with the liquidity of trading?
CATHERINE YOSHIMOTO: I think you referenced how certain governments are more willing to discuss. And so our policy group has been engaging with the Korean officials to look for improvements and basically look for how they can improve after stubbing their toes. So in consultation with basically our committees and feedback, it's really looking to maintain the stability. And rather than making a rash decision that might have to be reversed once certain fixes might be in place, that it would be in everyone's interest to maintain but continue the engagement with the officials.
And that's not for every situation. When Russia evolved, I believe FTSE Russell was the first index provider to remove Russia from the FTSE global equity index to make it an unclassified country. So it really depends on the situation. And in the case of South Korea, they have been open to feedback based on the market reaction.
PETER HAYNES: Mike, I'll ask you. As a user or an investor in global markets, how significant was the elimination of short selling to your perception of liquidity in that market? And were you of the view that South Korea should be maybe either put on a watch list at the very least, or even potentially moved from developed to emerging due to the short sell rule?
MIKE PERRY: So when I knew this question was being asked, I reached out to my trade desk who handles all the trading in South Korea for us. And 70% of that market is retail. So their initial reaction was short selling ban, not ideal. When you think about best practices for markets, you don't want to have that type of ban. And they're working to put some things in place that should eventually remove that ban.
They didn't see a material drop in liquidity, so no more difficult to trade there than it was before the ban was put in place. And I think it is a good question. Is it developed or is it emerging? I think the points have been made that, from an operational perspective, there's certainly things that are more emerging than developed. But when you look at a style perspective in terms of growth, GNI, it's more developed. 25% of that country's market cap is in Samsung, and Samsung gets 70% of its revenues from developed countries. So the exposure is more developed than it is emerging.
PETER HAYNES: You're using a different country benchmark. I'm sorry.
MIKE PERRY: So it's an interesting question. Certainly, from an exposure standpoint, an economic standpoint, there's no doubt that it's developed. Certainly, there's some operational issues that we would like to see resolved. We've seen an improvement in terms of free trading of currency that's expanded.
The short sell ban should be removed hopefully early this year. We've been able to trade in omnibus accounts in that market, which was an issue before. So we've seen real progress on the operational side. And we know from a pure standpoint, it's a developed country if you're looking at true exposure.
PETER HAYNES: The idea that a government decides they're going to do a real-life experiment and see what getting rid of short selling is going to do to the market, I'm worried about the results maybe not being strong enough for the government to understand the damage they're actually doing. And the retail ownership of stocks there clearly has an impact on the way that market--
MIKE PERRY: No doubt.
PETER HAYNES: --exists today, but maybe not how it will evolve. I just want to check with the audience here, if there's anyone that has any questions right now. Scott, is there anything on the anonymous?
SCOTT: There's been a lot of talk about trading disruptions around index additions and deletions. At what point does indexing become a crowded trade? For example, if we had 100% of the market indexing, I think you can imagine some bad things that might happen. So at what point does it become too much? Is it 50%, 75%, 95%? What are your thoughts?
PETER HAYNES: So, Mike, I think in the same article written by Cliff Asness we talked about earlier, I think Bogle was asked that question. And he said, 75% was his number. I'm just curious. Is that the number you might throw around in your office, or how do you guys look at that?
MIKE PERRY: So when you look at index membership and you look at ownership of companies owned by index funds, the ones that have a higher index ownership do not outperform the ones that have lesser index ownership. So that's point number one. There is a point where, like in the US, 30% of the market is indexed, approximately. Only 5% of the trading is from index flows, so 95% of trading happens from non-index players. There's still vibrant price discovery in the market.
Now, there's going to be certain examples of index changes like Tesla, certainly good example. But I think, in general, the markets are efficient over time. Maybe you can look at specific points in time and say, not efficient. Long periods, it is efficient. So what's the number? I'd say we have a long way to go.
JEAN-MAURICE LADURE: Yeah, I'd agree with that. I don't have a number to put on it either. I do believe that there's a long runway still to go. But there is a certain point, I think-- and the idea of equilibrium was brought up before where I don't think that it gets to a point where it's too crowded. I think that it gets to a point where other opportunities start to present themselves to the market, and participants start to take advantage of that. So I think that it will, in time, if it gets there, find its own soft spot rather than it being systematically problematic in the end.
PETER HAYNES: So, Mike, on that same vein, Vanguard has faced some scrutiny from naysayers and regulators actually, who suggest that you're contributing as a firm to what I think Sanford Bernstein referred to as the road to serfdom, where it suggested that communism was a better form of capital allocation than indexing. That would be where the critics are. And you get some scrutiny over your size. How do you respond to those criticisms as a firm?
MIKE PERRY: I think, in general, indexing has been a great win for investors in the world. Like I said before, costs matter. And when you look at the performance of low-cost funds, they outperform high-cost funds. We have an investment stewardship department that looks very closely at voting. We've got an effort in place to pass some of that voting through to larger shareholders. So you probably will see more of that happen. We're very conscious about-- our objective is to give our investors the best chance for investment success.
PETER HAYNES: And so my final question, I just want to talk about a key topic. It's come up a few times here today, and that's capping of benchmarks. We know in Canada, we dealt with this issue with Nortel several years ago. And in the US, capping has become a big topic, particularly around concentration in the large tech names.
If you're not in the US, you probably don't know what RIC rules are. But it seems that RIC rules are driving a lot of the decisions that index providers are making around capping. Can you explain what the RIC rules are that have driven S&P to, for instance, come up with new capping rules on your sectors, which include tech?
LOUIS BELLUCCI: Sure. So RIC rules are actually applicable to users of indices, the ETFs, mutual funds, and so on. The indices and the cappings, the methodologies that are put in place, are to support adherence to those RIC rules that downstream are actually subject to. The actual rules are that no individual security can-- or company can exceed 25% of the portfolio. And the sum of those with greater than a 5% weight cannot exceed 50%.
So a lot of that is driven, in the US, by RIC rules. There are equivalent rules such as UCITS in Europe, where we-- but I think what is interesting, from an index provider perspective, is we offer choice. And that's based on an individual's needs, whether that be an ETF provider or someone else that wants to maybe measure themselves in active approach versus a benchmark. We calculate uncapped indices. We calculate RIC Capped Indices. We calculate UCITS Capped Indices. We calculate equal-weighted indices, and so on, and so forth. The list goes on and on based on the individual use.
A purist might say that capping detracts from that core index objective. I do think that that's fair. I think that's fair to say. But at least in the US, for example, if an ETF were to lose RIC status, that is essentially the beginning of the end for that ETF. And it would be likely to be their demise and be to the detriment of the end investor, at the end of the day, as they lose things like the tax benefits of that RIC.
PETER HAYNES: So a lot of the RIC issues you've dealt with have been more specific to retail products and more specific, I guess, to certain funds that have dominant ETFs, for instance. There is a scenario, which is what we dealt with in Canada back in 2000, when you're talking about your primary benchmark, and you have users that are concerned about RIC rules but also ones that aren't. And I would put the S&P 500 into that category. Have you thought about what scenario would happen if you ran into concentration issues or RIC concentration issues for the 500, where you'd have a group of individuals that probably wouldn't want you to cap those names in your primary benchmark?
LOUIS BELLUCCI: Yeah, I mean, we'd have to speculate with those sort of things. We're nowhere close to that right now for that being a problem. So let's just to make that clear up front. The Canadian example is one where you could see it playing out that way, two versions of a capped and an uncapped based on the need or use case for downstream users.
I read something interesting. Rob, I think walked out. But in one of his papers, I think it was in 2018, he talks about how if you look at the top 10 weights or the top 10 market cap companies in the world, 10 years later, only three of them are still the top 10. So we're in an interesting period.
PETER HAYNES: Well, right now, they're all in the US.
LOUIS BELLUCCI: And they're all in the US, yes, but those-- we're in an interesting period where you do have very top-heavy concentrated indices. But it doesn't necessarily mean that that will continue. Its possible.
PETER HAYNES: I see. Secular versus cyclical is the question that everyone's asking right now.
LOUIS BELLUCCI: Absolutely. So it's something that has to be on the radar. But at this point in time, it's not ringing any alarm bells.
PETER HAYNES: And, Catherine, for value growth, Russell recently consulted on concentration issues around value growth, particularly the [INAUDIBLE] growth. Can you just talk about what you ultimately decided to do there?
CATHERINE YOSHIMOTO: Yes, we did make an announcement last Friday that we will be capping the Russell 1000 growth in value, et cetera, so the entire suite of the Russell-US-style indexes in order to support our clients, the index trackers who are bound by the RIC rules, which is specific to diversified, regulated investment company funds.
And as you say, potentially that could have been viewed as a retail problem. But as the Magnificent Seven has grown over the past several years, it has become a growing problem. And that's what led us to consult on it, because there are serious tax implications to not meeting those rules.
And so, yes, we consulted in August. And the feedback was majority supported the capping. Now, in terms of continuing to offer the uncapped version, yes, so that is our decision that we announced. First, we would apply the rule where-- we have a buffer, so 4.5% in aggregate, no more than 45% at the quarterly reviews, and with a 22.5% company cap. So that gives you a little bit of a buffer relative to the 25%, 550 that we talked about. And so that will be implemented beginning in March at the quarterly review.
But simultaneously, what will happen is from that review, the two indexes will diverge. So there will be an uncapped benchmark version and versus the standard Russell 1000 growth index, for example, will retain its name and index code and continue on as a capped version-- as the cap version. But we're not going to change the name because that's also difficult.
PETER HAYNES: You're not forcing people into a new benchmark. That becomes the continuity benchmark. If they want to stay with the existing rules, they've got to subscribe or take that. They've got to find a new benchmark.
CATHERINE YOSHIMOTO: They got move to the uncapped version.
PETER HAYNES: What I found really interesting about that review was this is the first time I've seen the fundamental community really engaged in an index-related consultation. And you appreciate how many fundamental investors use that Russell growth as their benchmark, even though they're active managers. And then you dig in a little bit and look at the holdings of those active managers. And, yeah, they're very concentrated in the same names, just with very different weights. I'm curious, JML, capping for MSCI, have you run into situations anywhere in your benchmarks where you're capping?
JEAN-MAURICE LADURE: Until this point, I mean, obviously our flagship indices are uncapped. We want to really capture the full investment opportunity without constraint, but then we've got all those options to add some caps on top of it if needed. What we've seen is actually, because we have such an extreme situation, some ETF providers-- we didn't realize that because they are a bit more concentrated indices, they haven't by default put some of those capping because they thought it would never touch those capping.
So we're having those discussions. It's more then a question about how to help our clients to migrate, to potentially add this extra layer on top of it. But I mean, really thinking-- I'm sure the two people sitting next to me, when you are head of index management research, you're getting paranoid of what could go wrong and what extreme situation can happen whereby the methodology itself may not exactly behave the way you want.
So even when things are not necessarily touched or are that extreme, we're spending a lot of time just saying, OK, what could we do wrong? Because it's a lot easier to modify the methodology. And if it's a material change, you consult with client before you do so, but to do it before then at the last minute when you are against the wall.
PETER HAYNES: Well, it's easy now for everybody to say, I want to invest globally, and I want to use the MSCI global benchmark. And then they look and see 70% of that developed benchmark is in the United States. Do you have anyone that's asking questions about whether-- or looking for versions of capping exposure to the US market at all? It's hard to do because it's outperforming right now. It plays into Rob's theme earlier of chasing. I'm just curious, is anyone asking you for that?
JEAN-MAURICE LADURE: I mean, we haven't any--
PETER HAYNES: They'll ask for it as soon as the market starts to roll over in the US and if that ever happens. So at any rate, I want to, on behalf of TD, thank our four speakers for joining us here today. Great discussion. Mike, thanks for joining the index panel too and--
MIKE PERRY: Thank you.
PETER HAYNES: --providing Vanguard's perspective. And we're going to take a 15-minute break. We'll see you back here around 10:40. Thank you.
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