An HKMIR paper explains benchmark index changes and shows their significant effects on mutual fund flows and international capital flows. Importantly, there is evidence for benchmark changes leading to an outperformance of upgraded assets, both at the time of announcement and the time of actual index adjustment.

Raddatz, Claudio, Sergio Schmukler and Tomás Williams (2015), “International Asset Allocations and Capital Flows: The Benchmark Effect”, Hong Kong Institute for Monetary Research, Working Paper 4/2015 .

The below are excerpts from the paper. Headings and cursive text have been added.

What is a benchmark effect?

“The benchmark effect refers to various channels through which prominent international equity and bond market indexes (such as the MSCI Emerging Markets Index or the MSCI World Index) affect asset allocations, capital flows, and asset prices across countries. These indexes have become popular and are frequently used as benchmarks by international mutual funds…Benchmarks allow the underlying investors and supervisors to evaluate and discipline fund managers on a short-run basis using, for example, the tracking error of the fund (the deviation of its returns from the benchmark returns)…Changes in the weights that a popular benchmark gives to different countries can trigger a similar rebalancing among the funds that track it and result in sizeable movements in international portfolio allocations and capital flows. Furthermore, because a growing number of mutual funds follow benchmarks more passively as a way to cut costs, increase transparency, and provide simple investment vehicles (such as index funds and exchange-traded funds or ETFs), the importance of the benchmark effect is likely to rise.”

How are benchmark indexes constructed?

“International benchmark indexes are typically constructed using a bottom-up approach and consist of composite stock or bond market indexes that include securities from many countries as constituents….[For example] MSCI first defines the main scope of a benchmark index (such as, geography, industry, and type of firms) and in which category each country is classified at each point in time (developed, emerging, or frontier). Then, it selects a number of securities that fall within the scope and meet the size, market capitalization, liquidity, and other requirements. Each of these securities gets a loading in the index portfolio assigned by the index producer according to how much it meets the index-construction criteria and how accessible it is to investors, given by the free-float market capitalization, restrictions to foreign investors, and so forth…each index captures the market capitalization weighted returns of all constituents included in the index.”

How do benchmark index weights change?

“On average benchmark weights move almost one-to-one with relative returns. Namely, changes in benchmark weights are on average driven by changes in a country’s relative market capitalization and, as such, exhibit a high degree of pass-through from relative returns at the monthly frequency.”

“At the same time, relative returns are not the only important determinant of changes in benchmark weights. In fact, the 2 of the various regressions [ratios of fluctuations explained by returns] are between 0.3 and 0.6 at the monthly level. The main reason for this is that benchmark companies revise the indexes regularly, leading to frequent re-weighting of all the countries, which is not captured by movements in market capitalization. These are the exogenous reallocations….and are independent of the performance of a country. Though most exogenous changes imply small reallocations, other ones are large… An example of large episodes is the upgrade and downgrade of countries across the developed, emerging, and frontier country category… Most of these country reclassifications are announced with certainty from 3 to 12 months prior to the effective date.”

Benchmark changes and mutual fund flows

‘We present thorough econometric evidence that movements in benchmark weights result in movements in the actual country weights of the funds that declare that benchmark, depending on their degree of activism.”

Benchmarks have statistically and economically significant effects on mutual fund allocations and capital flows across countries. Mutual funds follow benchmarks rather closely. For example, a 1 percent increase in a country’s benchmark weight results on average in a 0.7 percent increase in the weight of that country for the typical mutual fund that follows that benchmark. However, there is relevant heterogeneity across funds. Explicit indexing funds follow benchmarks almost one-for-one, generating some mechanical effects in allocations and capital flows. Although the most active funds in our sample are less connected to the benchmarks, they are still significantly influenced by their behavior, with about 50 percent of their allocations explained by the benchmark effect. These benchmark effects on the mutual fund portfolios are relevant even after controlling for time-varying industry allocations and country-specific or fundamental factors, among others.”


Benchmark changes and international capital flows

“Reallocations in the benchmarks directly impact capital flows through the reallocations in the fund weights. Furthermore, because the sensitivity of country flows to fund flows is partly mediated by the benchmark weight, the use of benchmarks might also generate amplification and contagion effects across countries. These effects arise from the impact that a shock to a country’s returns or to the returns of other countries in its benchmark has on its benchmark weight.”

“Large benchmark changes such as country upgrades and downgrades can have systemic effects on capital flows and asset prices. Moreover, they can lead to counterintuitive movements, including capital outflows and declining prices during upgrades, as well as inflows and higher prices in countries with deteriorating fundamentals…For example, while an upgrade from the emerging to the developed category typically implies good news, the weight of the country gets reduced because the country is much larger among emerging economies than among developed ones. Given that the pool of assets managed across developed and emerging markets is roughly similar, in many cases an upgrade implies capital outflows, while a downgrade leads to capital inflows.”

“By linking different countries in the same portfolio, benchmark changes can trigger reallocations across countries in that portfolio, connecting countries that might otherwise be disconnected (e.g., Qatar and U.A.E. with Argentina, Kuwait, Nigeria, and Pakistan in the MSCI Frontier Markets Index or Brazil, Russia, India, and China in the MSCI BRIC Index)… If a country, which has an important benchmark weight in an index, is moved to another index, countries in the original index should experience a considerable positive impact from this change as investors would need to reallocate their investments into the fewer remaining countries.”

Benchmark changes and asset performance

“We find, in fact, that large benchmark changes (such as upgrades and downgrades of countries) are associated with a return differential between stocks/debt included and not included in the benchmarks. Moreover, this differential behaves as predicted by the mutual funds flows; it becomes positive (negative) when there are predicted inflows to (outflows from) a country. Notably, these effects are present both during the announcement and effective dates of these benchmark changes. The cumulative differential returns are 1 percent around the announcement date and 3.5 percent around the effective date. Our results suggest that, through the reallocations they trigger, benchmark changes have effects on asset prices beyond the information content of upgrades and downgrades. The evidence is also consistent with limits to arbitrage in the markets affected by benchmark changes.”

Case study: Israel 2009-2010

“In June 2009, MSCI announced its decision to upgrade Israel from emerging to developed market status. In May 2010, the benchmark weight of Israel in the MSCI Emerging Markets Index turned zero and its weight in the MSCI World Index became positive. [The chart below] shows the behavior of the average weight of Israel among the explicit indexing and truly active funds that declare to follow the MSCI Emerging Markets Index and the MSCI World Index. Explicit indexing funds track the benchmark very closely. At the time the upgrade became effective, the funds that tightly follow the MSCI Emerging Markets Index instantly dropped Israel’s weight to zero, while those following the MSCI World Index incorporated Israel to their portfolios. However, when MSCI announced the upgrade decision, these funds did not significantly change their allocation in Israel; instead, they waited until the actual upgrade materialized. Truly active funds did not react so mechanically to the upgrade, but they still gradually adjusted their portfolio in a manner that is consistent with movements in the benchmark weights.”


Annex: Background of empirical analysis

“To conduct the research we compile a novel dataset of detailed portfolio allocations across countries by a large number of international mutual funds that we match with the allocations of the benchmarks they follow. The dataset covers the period from January 1996 to September 2014 and contains international mutual funds based in major financial centers around the world investing in at least two countries (i.e., it excludes country funds). A total of 2,837 equity and 838 bond funds are in the sample. These equity and bond funds collectively had 1,052 and 293 billion U.S. dollars in assets under management in December 2011, respectively.”

“Our two main sources for country portfolio allocations of international mutual funds are EPFR (Emerging Portfolio Fund Research) and Morningstar Direct (MS). Both sources include dead and live mutual funds.”