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Enhancements to theMSCI 10/40 Equity Indices
Consultation Document
April 2005

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Introduction to the consultationw

MSCI is consulting with investors on various approaches to enhance the MSCI 10/40 Indicesmethodology and to understand the implications of adopting the UCITS III directive(Undertakings for Collective Investment in Transferable Securities) on investors’ needs and theirinvestment process.

w

The main proposed enhancements to the MSCI 10/40 Indices include the following:
1.
2.
3.
4.

Address the revised investment constraints of the UCITS III directive by introducing the concept ofgroup entities.
Adopt a dynamic rebalancing algorithm to reduce index turnover in some configurations.
Adapt the treatment of some corporate events to reduce the frequency of rebalancing and hence index
turnover.
Accommodate indices with insufficient number of constituents to fully achieve the 10/40 constraints inorder to calculate “10/40 like” Indices by using more relaxed investment restrictions.

w

This presentation provides details of the various approaches to these proposed enhancements.

w

Importantly, this consultation may or may not lead to the adoption, in whole or in part,of the enhancements described herein and may not lead to any change to the current
MSCI 10/40 Indices methodology.

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I. UCITS III

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UCITS III - Introduction
w UCITS III is the European legislation that regulates certain funds sold acrossthe European Union (EU) member states.

w Introduced on February 13, 2002, the legislation consists of two main directives,

namely the product directive and the management company directive.

w Thereafter, several EU member states implemented UCITS III in their nationallaws by August 13, 2003 and effectively began applying these measures byFebruary 13, 2004.

w However, funds established under the original UCITS directive can elect either

to comply with UCITS III, or to continue with the original UCITS directive fora transitional period ending February 13, 2007.

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Introduction - UCITS III
w Under the UCITS III product directive, some of the changes implemented
are summarized below:
BeforeAfterw All investment restrictions assessed at the issuer

w Introduction of an additional group concept. Alllevel, namely:

investment restrictions will be additionally assessed at
the group entity level. The maximum weight ofsecurities issued by a single group entity cannot
exceed 20% of the total assets of a UCITS fund.

w The maximum weight of securities of any single

issuer cannot exceed 5% of the total assets of a UCITS
fund, except that the weighting in a single issuer can beincreased to 10% provided that the sum of the weights
of all issuers representing more than 5% of the assets
of a UCITS fund cannot collectively exceed 40%.

w Introduction of a relaxation for UCITS whose

investment policy is to replicate the composition of astock or debt securities index which is recognisedby national regulators:
w The maximum weight of securities issued by a single
issuer can be raised to 20% of assets
w The 20% level can be raised to 35% if justified by
exceptional market conditions.

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Impact on 10/40 Indices - UCITS III
w Following the introduction of a group entity concept under UCITS III,

investment restrictions have to be assessed at the group entity level inaddition to the issuer level.
w UCITS III refers to the directive on consolidated accounts, or international
accounting standards, for the definition of “group”.
• The consolidation of accounts is done for subsidiaries, in which the parentcompany:– holds more than 50% of the voting rights;– has the right to appoint/remove a majority of its board of directors;– has the right to exercise a dominant influence over the financial and operating
policies.

w In practice, the new group entity concept raises difficulties in its

implementation because the information on group entities may be incomplete
or often unavailable.
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Proposal - Investment Restrictions
w The table below summarizes MSCI’s proposal in response to the UCITS III

directive

Current MSCI 10/40 IndicesMethodology
The weight of any single issuer cannot
exceed 10% of the 10/40 Index.

Proposed MSCI 10/40 IndicesMethodology
No change.

The sum of the weights of all issuers
No change.
representing more than 5% cannot exceed
40% of the 10/40 Index.
No investment limit at the group entity
The sum of the weights of all securities oflevel.
all issuers within one single group entity
cannot exceed 20% of the 10/40 Index.
No definition of group entity.
If a listed issuer X owns at least 50% of theshares outstanding of at least one of theshare classes of another listed issuer Y, X
and Y combined will be considered as agroup entity.
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Rationale – Enhanced Investment Restrictions
w MSCI proposes to use a simplified definition of “group”, which may not fully

match the definition of the UCITS III directive, but will capture the mostimportant group entities on a consistent basis.
• For example, MSCI will not consider voting rights or dominant influence – rather
than share ownership – to consolidate group companies because such information
can be difficult to track or quantify and often involves subjective judgment rather
than objective and obtainable data.
• MSCI’s more narrow definition results in a straightforward and measurable method
to identify and maintain group entities.

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Proposal – Investment Restrictions Maintenancew The table below summarizes MSCI’s proposed maintenance procedureenhancement to the 10/40 Indices in response to the UCITS III directive.
Current MSCI 10/40 IndicesProposed MSCI 10/40 IndicesMethodology
Methodology
Rebalancing takes place as of theNo change.
close of the day when the index
weights break the 10/40 restrictions.
Companies forming group entities are Group companies as per MSCI’s
not monitored.
definition are monitored and changes
to group companies are reflected in
the indices as part of the regularlyscheduled quarterly/annual index
reviews at the end of February, May,
August and November.

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II. Dynamic rebalancing

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Introduction - Dynamic Rebalancingw

Under the current MSCI 10/40 Indices methodology, the indices are rebalanced
following a sequential 3 step process as follows:
1) The weight of any issuer which has a weight above 9% in the parent index is capped at 9%.
2) If the combined weight of all issuers having a weight above 4.5% represents more than36%, then the weight of any issuer with a weight between 4.5% and 9% is reduced in thesame proportion until the 36% limit is reached.
3) If the combined weight of all issuers having a weight above 4.5% represents less than 36%,
then the weight of any issuer with a weight between 4.5% and 9% is increased to reach the36% limit, if possible.

w

The above steps are effective for indices that have a relatively steep distribution ofsecurity market capitalization.

w

However, they are relatively less effective for indices with a flat distribution of security
market capitalization, where there may be numerous securities with weight above 4.5%.

w

In such circumstances, the current methodology systematically forces the weight ofsecurities between 4.5% and 9% down when, in fact, increasing some of their weight
could produce a more adequate result in terms of index turnover.
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Proposal - Dynamic Rebalancing% WeightA
9_Under the proposed methodology, the 3 sequential steps will be
replaced by a dynamic step which tests all combinations of A, B, Cand D, where the weight of issuers in B and D are decreased orincreased by a proportional factor.

8_

B

7_
6_

C

5_
4.5 _ _
4_

Looking for a solution with the:• lowest weight differential / turnover• lowest maximum relative weight increase
D3_
2_
1_0_Issuers

Max 36%

A: issuers capped at 9%

B: issuers > 4.5% (A+B=Large Cap)

C: issuers capped at 4.5% (Mid Cap)

D: issuers < 4.5% (Small Cap)12

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Detailed Example - Dynamic Rebalancing
Comparison of Current vs Parent and Proposed vs Parent
0.30
Increased Concentration in Largest Securities under new proposal...

0.20

0.10

0.00
-0.10
-0.20
-0.30

Potential liquidity
concerns exacerbatedby current method

-0.40
-0.50
-0.60
12 3 456 789 10 1112 13… but lower overall difference to parent

14 15 16

17 18 19

Security

20 21 22

23 24

Overall Difference to Parent = 5.72% for Current
Overall Difference to Parent = 3.56% for Proposedcurrent

proposed

1325 26 27

28 29 30
31 32 33
34 35

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Rationale – Dynamic Rebalancing
w MSCI’s proposal for dynamic rebalancing will provide the following benefits:• A more uniform methodology (one algorithm regardless of distribution)• Increased similarity to parent index (smaller sum of differences): more
representative• Lower turnover: more replicable• Fewer liquidity concerns for smaller issuers• More transparent in objective
w MSCI’s proposal for dynamic rebalancing may pose the following drawbacks:• Potentially greater concentration in largest securities in extreme cases• Potentially more complex to implement14

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III. Treatment of Corporate Events

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Introduction – Treatment of Corporate Events
w Under the current methodology, the 10/40 Indices are immediatelyrebalanced to the parent index whenever a constituent is added to theparent index.

w Additions can result from IPOs and other early inclusions such asmergers or spin-offs.

w Whenever there is new market capitalization entering the parent index(for example in the case of IPOs or mergers between index and nonindex constituents), it is difficult to determine at which weight this newmarket capitalization should be added to the 10/40 indices without
rebalancing to the parent index.

w However, in cases of spin-offs or mergers between constituents of the same

parent index, there is no new market capitalization entering the parent index
and the post-event market capitalization reflects a continuation of existing
constituents’ market capitalization.
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Proposal - Enhanced Treatment of Corporate Eventsw

A distinction will be made between additions that cause new market
capitalization to enter the indices versus those where no new market
capitalization enter the indices.

w

If a constituent spins-off a part of its business and if this spun-off entity will beadded to the parent index within the same country and industry, it will also beadded to the 10/40 indices at a fraction of the spinning off entity’s weight inthe 10/40 indices.

w

Similarly, if two constituents within the same country or industry merge, thenewly merged entity will be added to the 10/40 indices at the cumulative
weight of the 2 former constituents in the 10/40 indices adjusted for any cashthat might exit the indices.

w

Thereafter, the 10/40 indices are only rebalanced to the current index if the10/40 constraints are broken.
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Proposal - Enhanced Treatment of Corporate Eventsw

The 10/40 indices will continue to be immediately rebalanced to the parent
index when there is new market capitalization added to the parent index. Such
new market capitalization will be added in the following cases:– IPO or other early inclusion of non-index constituents resulting in
new market capitalizations being added to the index– Acquisition of a constituent company by a non-constituent
company– Merger between a constituent company and a non-constituentcompany– Changes in GICS classification (in the case of sector indices)18

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Rationale - Enhanced Treatment of Corporate Eventsw

The proposed enhanced treatment of corporate events recognizes thedifference between additions that change the underlying weights of the parent
indices versus those that are a continuation of the existing underlying weights.

w

As a result, this enhanced treatment helps to reduce index turnover by reducing
the number of rebalancings to the parent index.

w

Following this, enhanced rebalancings to the parent index would be restricted
only to quarterly index reviews and additions resulting in new market
capitalization entering the parent indices.

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IV. Accommodating Indices withInsufficient Constituents

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Introduction – Indices with Insufficient ConstituentsNo. ofconstituents

12345678
910111213
1415
16171819w Under the current methodology, there must be at least

Weight in
10/40 Index

9%
9%
9%
9%
4.3%
4.3%
4.3%
4.3%
.
.
.
.
.
.
.
.
.
.
.

36%

19 issuers in the parent index, as a 10/40 index using a
10% buffer (9/36/4.5) cannot comply with these limits
if it has less than 19 issuers.

w This poses a problem as 10/40 indices are discontinued

as soon as the number of constituents in the parentindex falls below 19.

64%

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Proposal & Rationale – Indices with Insufficient Number ofConstituentsw Under the proposed methodology, the minimum number of constituentsrequired to calculate “10/40 like” indices decreases from 19 to 15 with morerelaxed constraints such as 13/4.5/52.

w Customized branding will apply to these indices as they are not subject to the10/40 constraints.

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Proposal & Rationale – Indices with Insufficient Number ofConstituents

Cap 1

With 10% Buffer
Cap 2
Minimum
constituents

Proposed: With 8% Buffer
Cap 1

Cap 2

Minimumconstituents

1040191040

181050181144171060

1712481610701613521510801514561523

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Notice and Disclaimer
Copyright © 2005 by Morgan Stanley Capital International Inc. ("MSCI").
All rights reserved.
The MSCI Consultation Document and any related Questionnaire (the “Consultation Documents”) may not be reproduced or redisseminated in whole or in partwithout prior written permission from MSCI. Any use of MSCI indices, data or other information requires a license from MSCI. The information provided in theConsultation Documents is for informational purposes only and does not form a part of the terms or conditions of any agreement you have or may enter into withMSCI. The information may not be used to verify or correct other data, to create indices, or in connection with offering, sponsoring, managing or marketing any
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About MSCIMSCI (www.msci.com) is a leading provider of equity, fixed income and hedge fund indices, and related products and services. MSCI estimates that over USD 3
trillion is benchmarked to its indices on a worldwide basis. MSCI is headquartered in New York, with research and commercial offices around the world. In 2004,MSCI acquired Barra, Inc. (www.barra.com), a global leader in delivering risk analytics, performance measurement and attribution systems and services to managersof portfolio and firm-wide investment risk. Morgan Stanley, a global financial services firm and a market leader in securities, asset management, and credit services, isthe majority shareholder of MSCI, and Capital International Inc., part of the global investment management group of The Capital Group Companies, Inc., is theminority shareholder.

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