The case for a new look at global benchmarks

Indexes are important for pension funds. They benchmark the fund’s performance against goals and peers. They allow the fund’s managers to be measured and often times they decide the managers’ remuneration. You would think, then, that there must be a lot of science behind their use.

That is difficult to see, on the face of it.

One of the most commonly used indexes for global equities is the MSCI World. This does not, however, include emerging markets.

Pension funds can either tack a separate emerging markets index on – or not  – or use the MSCI All Countries World Index instead. Emerging markets, however, make up only about 13 per cent of ACWI even though the economies they represent make up more than 40 per cent of the world’s GDP.

Pension funds can adjust this for their own purposes, of course –  or not – depending on the resources they have at their disposal.

Within the emerging markets universe, for indexing purposes, individual countries are ranked and grouped according to a range of factors including the level of free floats, or how investable the index is, and capital market development, governance and other factors.

If you’re not yet convinced the benchmarking system readily available to pension funds is flawed, consider this: under MSCI’s process, China is ranked behind Egypt for “emergedness”. One wonders whether the MSCI people have ever been to Egypt.

Dr Arjuna Sittampalam, a research associate with investment risk advisory group EDHC-Risk Institute, has now questioned the whole concept of emerging markets, suggesting in a recent note to clients – primarily pension funds and funds managers – that the notion of emerging markets needs to be reviewed.

He points out that each of the BRICs (Brazil, Russia, India and China) has less debt as a proportion of GDP than the top 10 developed countries. China’s debt, which is the highest of the BRICs, is still only one-eighth that of the US and UK.

The BRICs’ growth story is well-known and made more obvious through the difficulties most developed countries have had in climbing out of the global crisis by comparison.

However, while Dr Sittampalam believes the distinction between developed and emerging should be abolished, he sounds a note of caution for investors who have piled into emerging markets in the past two years as they reweight portfolios to growth assets.

“According to the well-known Professor Elroy Dimson, of the London Business School, the economies growing the fastest produce the poorest equity market returns by a large margin, based on decades of data from 53 countries,” he says.

But benchmarks are not primarily designed to make money. They are tools for measurement. As such, very large pension funds have the advantage of being able to build bespoke benchmarks according to their own circumstances and view of the world.

To make money, Dr Sittampalam offers some further advice: “The conclusion is that not only might there be a growing case for the distinction between ‘emerging’ and ‘developed’ to be abolished … but also that fund managers who look at companies on their individual merits irrespective of country will probably do better.”