The value of knowing how a benchmark index is constructed
Value-based indices may be broadly representative of the value style of investing but an analysis of how they are constructed can be an instructive exercise for those considering using one as a performance benchmark
Clearly investors should be monitoring how their fund managers are performing against their available investment universe but, equally, they need to ensure whatever other benchmark they are using to measure that performance is appropriate.
To illustrate this point, let’s consider how one of the most used value benchmarks from one of the very largest index providers – MSCI’s World Value index – is constructed.
While the broader MSCI World index is made up of around 1,600 stocks, its more style-oriented offspring – the MSCI World Growth and MSCI World Value indices – comprise some 900 stocks each.
Simple maths suggests there must be some kind of overlap here and indeed the 200-stock discrepancy is explained by the way MSCI decides if a business should be categorised as ‘growth’ or ‘value’.
What is growth and value?
What MSCI does is award each stock in its broader World index an overall style characteristic derived from certain value and growth scores and then place those stocks accordingly – or else it partially allocates them to both indices.
As things stand then, some 170 stocks – that is, around 10% of the whole MSCI World universe – actually crop up in both the MSCI World Value and the MSCI World Growth benchmarks.
To define the overall style characteristic of any stock, MSCI uses a total of eight variables, some of which are historical and some forward-looking. Five of the variables are growth-oriented while three relate to value, with the latter trio comprising a business’s dividend yield and its ‘book value to price’ and ‘12-month forward earnings to price’ ratios.
Now, there is a lot we could write on how taking metrics such as book value to price ratio and dividend yield at face value can get investors into trouble – indeed we have in pieces such as Why yield cannot be the sole driver of an investment decision.
Nevertheless, those are two broadly sensible backward-looking measures that investors can use to make informed decisions.
As for the 12-month forward earnings to price ratio, well, let’s just say that regular visitors to The Value Perspective will be well aware of our views on the futility of trying to forecast the future.
Still, those are the three metrics that help MSCI to arrive at the 900 or so stocks in its World Value index – at which point we find another curious aspect of the construction blueprints.
Weighted by Market Cap
A key point any user of the MSCI World Value index must understand is its constituents are weighted by market capitalisation – that is, the total number of shares a company has in issue multiplied by its current share price.
Say, then, you own a fund that tracks the index, the factor to which you have most exposure is not value but size of business, with the top 10 holdings all having markets caps in excess of $220bn (£171bn).
Another feature of the MSCI World Value index that is often overlooked is the way the overall country and sector weightings are closely tied to those of the benchmark’s non-value parent, the MSCI World.
This is why the MSCI World Value has two-thirds of its exposure in the US – even though, versus its long term history, the world’s largest market currently stands at one of its most expensive points ever.
It may seem a bit harsh to home in on a single index but MSCI is big enough to take it and it certainly helps better illustrate some specifics of a more general yet crucial point – that while value benchmarks will display some value characteristics, investors must understand their methodology and construction mean a truly unconstrained value portfolio will look very different.
As a result, furthermore, the performance of any truly active value fund over short time periods is very likely to prove volatile versus a value benchmark.