A little while back, The Wall Street Journal ran an article with a puzzling title: “How China Pressured MSCI to Add Its Market to Major Benchmark.” Like a lot of market news, this arcane-sounding story came and went without much notice. But it is worth pausing to understand what it was all about, and why it should matter to you.
First, let’s decode the terminology in the article’s headline: A “benchmark,” is another word for an index and is simply a list of stocks (or other investments). Probably the most well known indexes are the Dow Jones Industrial Average and the S&P 500, but there are many others.
And who is MSCI? While lesser known than its competitors Dow Jones and S&P, MSCI is a major player in the index business. They have created thousands of indexes, and last year that business generated more than $800 million in revenue.
While MSCI’s name is not well known, it is an influential company. That is because thousands of index funds are built on their indexes. As a result, when MSCI adds a stock to one of its indexes, some number of mutual funds immediately rush to buy that new stock, and this often drives up the price of that stock.
Ordinarily, index providers receive little attention as they operate quietly in the background. They move methodically and make changes to the composition of indexes only incrementally. In its most recent update, for example, the S&P 500 replaced just one stock out of five hundred.
But every once in a while, an index provider does something surprising. In the most recent case, according to the Journal, MSCI succumbed to pressure from China’s government to make sweeping changes to one of its most well known indexes. Specifically, according to the accusation, China requested that MSCI add more Chinese stocks to its Emerging Markets Index—an index to which trillions of dollars of index funds are linked. This “request” was accompanied by threats, via intermediaries, that MSCI would see its business in China curtailed if it didn’t comply. According to the Journal‘s sources, MSCI had a hard time standing up to this pressure and soon thereafter added hundreds of Chinese stocks to its Emerging Markets Index. They have added even more since and are considering adding many more still.
The result: Over the past several months, emerging markets index funds have been buying billions of dollars of Chinese stocks—just as their government wanted.
As a financial advisor, I find this distasteful on a number of levels. Of course, there is the principle of it; no one should bow to the demands of a repressive regime. Beyond that, radical index changes are unwelcome because they often carry tax consequences for investors. And finally, I believe this change detracts from the Emerging Markets Index because it diminishes its geographical diversification. China already represented the largest segment of that index. Now it is that much larger, and may get larger still. That, in my view, makes funds tied to this index riskier and less attractive investments.
As an individual investor, what can you do? Here are three recommendations:
1. Be vigilant: In recent years, index funds have exploded in popularity. Overall, I see this as a good thing. But the MSCI story is a reminder to remain vigilant. Just because an investment carries the word “index” in its name does not automatically make it a good investment. Far from it. There are now thousands of index funds—some good, some bad, some terrible—so always know exactly what you’re buying.
2. Stay close to home: Many investment firms recommend investors allocate their dollars in proportion to the size of international markets. I don’t accept that notion. If you followed that prescription, domestic stocks would make up barely half your portfolio, with the rest distributed around the world. In my view, just because a market exists doesn’t mean you should feel any obligation to invest in it. Indeed, episodes like this are a perfect illustration of why I think investors ought to limit their exposure to international markets, especially emerging markets.
3. Look under the covers: These days, there are thousands of different index funds, many of which carry similar names, even within the same fund family. Consider, for example, iShares MSCI Emerging Markets ETF and iShares Core MSCI Emerging Markets ETF. It would be easy to confuse the two. A closer examination, though, would reveal several differences—including a nearly 5x cost difference. This is just one example. The lesson: Always examine a fund inside and out before investing.