Consultation on Potential Ideas for Index
Stability and Replicability Enhancements
September 2011

©2011. All rights reserved.

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Introduction
 For over 40 years, MSCI has constructed global equity benchmark indices thatassist the international investment management process
 The MSCI Equity Indices serve investors’ needs by being: Relevant and precise performance benchmarks
 Effective research and asset allocation tools
 The basis for investment vehicles designed to gain and/or manage exposure to different
segments of the global equity markets

 Index needs of investors have evolved over time and have been addressed byenhancements to the MSCI Indices. Some of the recent enhancements include
 Improvement of the index investability through introduction of the short-term liquidity
requirements (2010)
 Increase in the index stability via enhancing the Size & Coverage Target Area (2011) The objective of this consultation is to seek the investment community’s feedback
on MSCI index construction and calculation methodologies in order to identify
areas for potential methodology enhancements with respect to index replicability
and efficiency©2011. All rights reserved.

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2

Key Properties of Benchmarks
Property

Description

Main Current Features

Potential Enhancement Areas

Replicability

It should be possible topassively replicate thebenchmark• Availability of local equities to nondomestic investors• Liquidity screening of securities in theindex• Use of replicable prices and FX rates forindex calculation• Advance notice of index changes

1. Exchange rates used in the calculation of
MSCI Indices2. Prices used in index calculation and offexchange liquidity
3. Inclusion of depositary receipts in the MSCI
indices
4. Free float market capitalization and liquidity
requirements for inclusion in the MSCI
Global Standard Indices5. Tax treatment for the net total return index
series
6. MSCI index correction policies
7. Treatment of corporate events between
index review announcement andimplementation dates

Efficiency

A benchmark should be as
stable and simple as possible, inorder to keeping replication
costs relatively low• Quarterly rebalancing schedule balances
representativeness with a reasonable
number of index changes• Buffers at various levels of index
construction prevent reverse turnover andreduce replication costs

1. Fair value pricing
2. Potential gaming mitigation measures
3. Index review frequency

RepresentativenessA benchmark should bereflective of the investment
process it aims to represent• Balancing size integrity and coverage toachieve a consistent set of global indices• Providing meaningful size, country, styleand industry segmentation of theinvestable universe

1. Definitions of size integrity in DM and EM
2. Country classification of securities
3. Voting rights in index construction©2011. All rights reserved.

msci.com3 Index Replicability©2011. All rights reserved.

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Exchange Rates Used in the Calculation of MSCI Indices MSCI currently uses WM/Reuters Closing Spot Rates, taken at 4 PM London time
to calculate all of its equity indices The current approach enables MSCI to calculate regional levels using synchronous exchange
rates However, it also has disadvantages
 For some currencies (for ex., KRW and TWD) with no offshore trading, the WM/Reuters 4PM London time rates might
not be achievable Exchange rates used are not being synchronous with security prices, potentially causing tracking error on index review
or corporate events days

 Discussion points
 Do you see any issues with respect to the current MSCI policy for exchange rates?
 Should MSCI switch to different time fixings for the calculation of the official closing index
levels?
 If yes, should the timing of these rates coincide with the close of the equity market / time when the currency trading ismost liquid in every country/region?
 If not, would there be value in providing, in addition to the official closing index levels, snapshots per region using theexchange rates corresponding to the close of each region?

 Are there any other enhancements with respect to exchange rates used that you would like to
see implemented in the MSCI index calculation?

©2011. All rights reserved.

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Prices Used in the Calculation of MSCI Indices and OffExchange Liquidity (1/2)
 MSCI currently calculates index levels using the official exchange closing
prices or figures accepted as such (typically, auction close, last traded or
VWAP price) Discussion points Would a single method of calculating the closing price (for example, systematically using
VWAP) be preferable to the current policy?
 Do you see a need in providing additional intraday snapshots of the indices using
intraday prices?
 Is there a case for adding additional price sourcing from non-exchange venues?
 If yes, in which cases?

 Are there any other enhancements with respect to prices used that you would like to see
implemented in the MSCI index calculation?

©2011. All rights reserved.

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Prices Used in the Calculation of MSCI Indices and OffExchange Liquidity (2/2)
 The market share of equities trading by
mainstream stock exchanges has fallen in the
recent years

 A significant portion of equities trading isaccounted by venues such as Dark pools andElectronic Crossing Networks (ECN) Around 45% of US equities turnover occurs outside
mainstream stock exchanges, while for Europe, thecorresponding figure is about 40%

 Discussion Points
 How important are these
additional sources of liquidity
in your investment process?
 Should MSCI consider the useof these additional sources ofliquidity to enhance its ATVR
and frequency of trading
calculation?
Source: Reuters market share reporter. Market share data as of Jun 2011. ADF stands for alternative display facility created by FINRA. The
traditional stock exchange turnover includes the trading turnover on the exchange as well as the trades reported on the exchange©2011. All rights reserved.

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Inclusion of depository receipts in the MSCI indices In general, only local company listings are eligible for inclusion in the MSCI Indices However, when a local listing has low liquidity and depository receipts (DR) withhigher liquidity trade in the same time-zone, DRs may be eligible for index
inclusion (for example, the Magnit GDR London listing) Exceptionally, U.S. listings are eligible for the MSCI Russia Index despite being in a different
time-zone

 Discussion points
 In your opinion, should DRs in general be eligible for inclusion in the MSCI Indices?
 Should full fungibility be a requirement for the eligibility of DRs?
 Should DR premiums / discounts be a consideration for their eligibility?
 Is there a case to only include DRs in markets that are difficult to access, even if the liquidityof the DR is lower than the local share (but still fulfilling the requirements of the MSCI Global
Investable Market Indices on an absolute level)?
 If yes, in which markets (e.g., Russia, Brazil, India) ?

 How important are time zone considerations when including both DRs and local listings in thesame country index?
 For example, should the TEVA PHARMACEUTICAL DR be eligible for inclusion in the MSCI Israel Index?

©2011. All rights reserved.

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Free Float Market Capitalization and Liquidity Requirements
for the MSCI Global Standard Indices (1/2)
 Two levels of free float market capitalization and liquidity screenings are applied for
the MSCI Global Standard Indices:1.

Absolute free float market capitalization (half of the universe minimum size reference) and liquidity
screenings (20 and 15% minimum ATVR respectively for DM and EM) are applied to derive the equity
investable universe and are common to the Standard and Small Cap indices2.

Additional market relative screens are applied to constituents of the MSCI Global Standard indices withthe aim of ensuring even higher investability for this segment


Approximately 200 securities in the MSCI ACWI universe do not fulfill these additional requirements representing 7% of the
securities in MSCI ACWI and 45 bps in market capitalization

 These additional screens result in some securities from the Small Cap index thatwould otherwise migrate to the standard index being deleted from the Investable
Market Index (IMI) as they have too large a market capitalization for the Small Cap
index but do not satisfy the additional requirements for inclusion in the MSCI Global
Standard Indices Discussion PointsAre higher investability requirements needed for the Standard Indices than for the Small Cap?


If yes, should they be defined relative to the market of the country or be absolute

The investable universe liquidity requirement is currently higher for DM (ATVR of 20%) than for EM (ATVR
of 15%). Should these requirements be harmonized?
Based on the May 2011 index review data, increasing the minimum investable universe ATVR threshold to 20% would lead to nodifference in index constituents©2011. All rights reserved.

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Free Float Market Capitalization and Liquidity Requirements
for the MSCI Global Standard Indices (2/2)
Country Additional
Standard Index Minimum
ATVR Requirement©2011. All rights reserved.

Free Float Market Cap Distribution of securities ineligible for the
MSCI Brazil Index due to additional float market capitalization
requirements

6
5

4
3
2

1
0

16

Float Market Cap Distribution in MSCI Brazil

14

12
10
8
6

35

ATVR Distribution in MSCI China

4

30

2

25

0

20

15

14 securities are ineligible representing 1.9% of the MSCI Brazil market cap
All market capitalizations in USD MM
Securities representing less than 10% of issuer market capitalization are
excluded from the statistics
Data as of May 2011 index review

10
5

More

190%

180%

170%

160%

150%

140%

130%

120%

110%

90%

100%

80%

70%

60%

50%

0

40%

The additional Standard Minimum ATVR Requirement
is defined in reference to the corresponding country
Standard Index universe

7

Da ta a s of Ma y 2011 i ndex revi ew

30%

31.8%
24.5%
28.6%
50.0%
50.0%
20.3%
47.9%
20.0%
30.2%
50.0%
21.2%
50.0%
15.2%
25.6%
49.3%
39.5%
26.4%
50.0%
48.2%
20.5%
26.7%
16.2%
22.0%
46.9%
50.0%
50.0%
15.0%
15.2%
22.2%
41.6%
33.7%
33.4%
33.5%

20%

CA
US
EU
IL
AU
HK
JP
NZ
SG
CZ
EG
HU
MA
PL
RU
ZA
TR
CN
IN
ID
KR
MY
PH
TW
TH
BR
CL
CO
MX
PE
DM (avg)
EM (avg)
ACWI (avg)

Securities not included in the Standard Indicesdue to additional Standard Index Min. ATVR
requirement
Country
Security NameATVRPLING BANK SLASKI SA
17%
CN
CHINA DATANG CORP REN H 20%
BR
AMBEV ON
22%
RU
OGK-4 (RUB)25%
RU
TGK-1 (RUB)
26%
KR
LG CORP PREF (NEW)26%
RU
OGK-5 (RUB)
27%
BR
COMGAS PNA
28%
RU
PHARMSTANDARD GDR29%JPHANKYU HANSHIN HLDG
29%
BR
LOJAS AMERICANAS ON
29%
IN
CADILA HEALTHCARE
31%
ZA
MEDI-CLINIC CORP
31%
BR
CEMIG ON
32%
TW
HOTAI MOTOR COMPANY33%
CN
YANTAI CHANGYU PIONEER B 33%
IN
GODREJ CONSUMER PDTS
36%
RU
IDGC HOLDING (RUB)39%
CN
SPRINGLAND INTL HLDGS40%
AUNEW HOPE
41%
BR
ALPARGATAS SAO PAULO PN 42%
RU
TATNEFT PREF (RUB)
45%
BR
GUARARAPES CONFECCOES ON 45%
RU
NOVOROSSIYSK PORT GDR
49%
CNNEW WRLD CHNA LND(CN)
49%

10%

Country

msci.com10

Tax Treatment for the Net Total Return Index Series The net total return index series aims to capture the effects of withholding
taxes on dividend reinvestment
 The regular cash dividend is reinvested after deduction of withholding tax
by applying the maximum rate of the company’s country of incorporation
applicable to institutional investors. MSCI uses the maximum rateapplicable to non-resident institutional investors who do not benefit fromdouble taxation treaties.
 Discussion points
 Is there a need to provide more versions of the net total return series with tax
assumptions based on different countries of residencies / type of investors ?

 Are there any other enhancements with respect to tax rates used in the net total returnindex calculation that you would like to see implemented in the MSCI index calculation?
 Is there a need of an after-tax returns index (for example, incorporating the capital gains
tax for index rebalancing) ?

©2011. All rights reserved.

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11

MSCI Historical Index Level Correction Policy In general, restatements due to incorrect dividends and prices are
implemented on the day when the error is discovered Historical index levels (in the past 12 months) are restated when the index level impactof the correction on a country or sector index is larger than 50 basis points
 In certain circumstances, if MSCI determines the error is significant enough to justify therevision of indices impacted by less than 0.5%, MSCI reserves the right to correct
information even if the impact is lower than the above limit

 Discussion Points
 How do index level restatements impact your investment processes?
 What are the impacts in terms of data redistribution / loading ?

 Is this historical correction threshold of 50 bps appropriate?
 Is there a distinction to be made between self-correcting (for example, wrong price) and non self-correcting(for example, wrong dividend) errors?
Correction Threshold (bp)
Number of potential historicalcorrections per year*

1

5

10

25

50**

27.4

22.7

22.4

20.6

19.8

* Statistics based on ACWI country standard indices for May 2007 - Mar 2011** Annualized number of actual corrections for the May 2007 - Mar 2011

©2011. All rights reserved.

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MSCI Index Review Correction Policy
 Index changes due to index reviews are typically announced two weeks
prior to the implementation date When a discrepancy is discovered after the index review announcement
date, the index composition is typically adjusted before theimplementation date of the index review.
 While in some cases (for example, insufficient trading liquidity for additions) it is the
only possible solution, in others (for example, late identification of an addition or a
relatively small change in the security index market capitalization), implementation
could be potentially deferred to the next index review

 Discussion Points
 Should MSCI postpone index review corrections to the following index review wheneverpossible?
 Should there be a cutoff date (e.g., 5 days prior to rebalancing) after which index review
corrections that can be postponed will not be implemented?
 For instance, the addition of Magnit GDR in the MSCI Russia Index at the time of the May 2010 SAIR wasannounced 3 days prior to the implementation. Should such an addition be postponed to the next index
review?

©2011. All rights reserved.

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Treatment of Corporate Events Between an Index Review
Announcement and the Implementation Date
 If there are significant and highly probable corporate events affecting asecurity after the announcement date, decisions that were announced
may be reversed
 For example, if a new company that is planned to be added to the index on the 1st ofJune is affected by a corporate event that would prompt its deletion on the 3rd of June,the decision on addition may be reversed

 Some recent examples include: reversal of May 2011 SAIR additions of Equinox in
Canada, Wood Group in the UK, Danisco in Denmark Discussion Points
 Is this treatment appropriate for your investment process?

 In your view, how should MSCI deal with corporate events that occur between an index
review announcement and the implementation date?
 Should there be a cutoff date (e.g., 5 days prior to rebalancing) after which index review
corrections that can be postponed will not be implemented?

©2011. All rights reserved.

msci.com14 Index Efficiency©2011. All rights reserved.

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Fair Value Pricing
 MSCI calculates its equity indices using closing prices
 When the MSCI ACWI Index is computed (after the close of American
exchanges), some of the prices used in the calculation (e.g., for markets in Asia)
may be late by many hours
 The fair value of these assets is likely different at that time

 Under the Investment Company act of 1940, funds and theirdirectors have a regulatory obligation to make a good faith
determination of the fair value of the funds' portfolio securities
when market quotations are not readily available
 Open-end mutual funds tend to use fair value rather than closing prices tocalculate their NAV and reduce the opportunities for arbitrage

 Discussion Points
 How does the fair valuation pricing affect your investment process?
 Do you see a need for fair value indices provided by MSCI?

©2011. All rights reserved.

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Potential Gaming Mitigation Measures
 The MSCI GIMI are currently reviewed on a quarterly basis with changes announced
approximately 2 weeks before implementation and based on a pricing date approximately 7
weeks before implementation
 Passive indexers typically apply these changes very close to the implementation date to minimize
tracking error Short term speculators may potentially game this process by buying additions to the index andselling deletions prior to implementation
 This effect reverses shortly after the implementation date
 Conceptually, this potentially results in subtracting some performance from the indices (that buy high and selllow)

 Discussion Points
 Is this index gaming effect a concern in your investment process or for your clients?
 Possible ways to mitigate this effect include
 Reflecting changes in the equity universe (e.g., smaller IPOs) on an ongoing basis
 In that case, only migrations due to performance would be implemented during scheduled index reviews
 Spreading changes due to index reviews over several days/weeks (e.g., implementation of 1/10th of weight changes per day) Lengthening the period between announcement and implementation dates Randomizing index review dates
 Providing an option to customize the index review / implementation dates

 In your view, should MSCI Indices be reviewed to minimize short term trading and if so, how?

©2011. All rights reserved.

msci.com17

Index Review Frequency
 MSCI Global Market Investable Indices (GIMI) are reviewed on a quarterlyschedule During the May and November semi-annual index reviews, the complete equity universe(eligible stocks, number of shares, free float) is reviewed and size classifications arereassessed During the February and August quarterly index reviews, only the impact of significant
market events (large IPOs and big changes in free float and number of shares) arereflected in the indices Discussion Points
 Is this index review frequency appropriate?
 A relatively small number of changes are happening to the indices during the Februaryand August index reviews (approximately 10-20 index segment changes vs 100-150 for
the May and November index reviews)
 In your opinion, should MSCI fully reassess the investable universe and the size classification during Februaryand August index reviews (i.e., make them the same as the current May and November reviews) ?
 If not, would it be preferable to only keep the May and November index reviews and rebalance the MSCI GIMI
Indices on a semi-annual basis?

©2011. All rights reserved.

msci.com18 Index Representativeness©2011. All rights reserved.

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Definition of the Size Integrity in DM and EM (1/2)
 The MSCI Standard Indices balance size integrity (USD 4 billion*) andmarket coverage objectives (85%)
 In case of a conflict, size integrity takes priority over market coverage The size range for EM countries is currently set to be half of the DM one
 Some larger EM countries (for ex., Mexico, Brazil, Russia) are currently over-represented
as a result of this rule

 Discussion points
 How is size integrity defined in your investment process?
 Is a different definition of size integrity used for DM and EM ?
 How is size integrity balanced with market coverage objectives?
 Is the 80-90% market coverage target still appropriate for the Standard Indices?
 How is size integrity defined for FM (Frontier Markets) ?

 Should MSCI switch to a common definition of size integrity for both EM and DM in theconstruction of the MSCI GIMI Indices?
* Data for DM as of the May 2011 Index Review©2011. All rights reserved.

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Definition of the Size Integrity in DM and EM (2/2)
Current definition of size integrity for DM and EM
1.15 X Minimum Size
Reference, USD 4,646

5,000

5,000
US

4,500

4,500

EU

4,000

Minimum Size
Reference, USD 4,040

3,500

4,000

CA

3,500

HK
AU

SG

3,000
2,500

0.5 X Minimum Size
Reference, USD 2,020

2,000
1,500

2,500

1.15 X Minimum Size
Reference, USD 2,323

2,000Minimum Size
Reference, USD 2,020

ID
TH

1,000

0.5 X Minimum Size
Reference, USD 1,010

1,000
75%

80%

85%

90%

95%

100%

70%

CZ

PH
TR

1,500

70%

HU

CO

BR

RU

3,000

JP

IL

MA

MY

MX

ZA
KR
CN
CL
IN
PL

EG
TW
80%

75%

85%

90%

95%

100%

Data as of the May 2011 Quarterly Index Review

Simulation using the same definition of size integrity for DM and EM
5,000

5,000

1.2 X Minimum Size
Reference, USD 4,570

4,500

4,500

US

4,000

4,000

EU
Minimum Size
Reference, USD 3,808

3,500

CA
AU

SG

HU

Minimum Size
Reference, USD 3,808

MX
ID

2,500

0.5 X Minimum Size
Reference, USD 1,904

BR

MA

3,000

2,500
2,000

RU

3,500

HK

3,000

1.2 X Minimum Size
Reference, USD 4,570

JP

0.5 X Minimum Size
Reference, USD 1,904

2,000

IL

TW

1,500

PL

MY

PH

1,500

1,000

TH

TR

CL
IN

ZA
CN
KR

1,000
70%

75%

80%

85%

90%

95%

100%

70%

75%

80%

85%

90%

95%

100%

Simulation based on data as of the May 2011 Quarterly Index Review©2011. All rights reserved.

msci.com21

Country Classification of Securities
 The country classification of a security is generally determined by the country of incorporation of
the issuing company and the primary listing of the security. This approach determines thecountry classification of approximately 94% of securities in the MSCI Equity Universe When a company is incorporated in one country while its securities have a primary listing in a different country,
additional factors such as the geographical distribution of its shareholder base and operations (assets andproduction) are considered This approach has limitations
 For example, some mining companies incorporated and listed in Canada or UK may point to other countries withrespect to their assets and revenue distribution, e.g., Pacific Rubiales Energy, Kazakhmys, Randgold Resources

 In cases where the countries of incorporation and primary listing do not match and the geographical economic
exposure points to a third country, the company can become ineligible for any of MSCI Indices (e.g., Vimpelcom,
X5, Rusal, Prada, Samsonite) Discussion points
 What are your views on how country classification of securities should be done?
 How important are time zone considerations when constructing country indices (e.g., would it be theoreticallyconceivable to mix stocks traded in the US and Hong Kong in the MSCI China Index) ?
 Should MSCI consider the geographical economic exposure of a company as the main factor for country
classification, replacing current rules?
 If not, should it be used as one of the factors determining the country classification?
 If not, is there value in providing a secondary classification according to geographical economic exposure in addition to the primary country
classification that could be used in the construction of potential new economic exposure indices?

©2011. All rights reserved.

msci.com22

Voting Rights in Index Construction
 MSCI currently does not use any corporate governance criteria for theconstruction of the MSCI GIMI
 In some instances, it can result in inclusion of stocks of questionable value from a
corporate governance standpoint For example, the CEO of one of the constituents of the MSCI Russia Index publicly stated that
his company “will not become a cash cow for the owners of preferred shares” and that thecompany’s minority shareholders try “to sweep the crumbs from *the company+’s table onto
their own plate” *source: the company’s website+ Discussion points
 Should MSCI consider corporate governance as one of ground rules in index construction?
 If yes, what corporate governance eligibility rules would be desirable?
 One possible rule would be to reduce the weight of securities according to their voting rights
 For example:- a share of VOLVO B has 10 times less voting power than VOLVO A- BMW VORZUG has no voting power compared to BMW STAMM- PORSCHE listed shares do not have any voting power.
All these stocks are currently eligible for inclusion in the MSCI indices©2011. All rights reserved.

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Notice and Disclaimer
This document and all of the information contained in it, including without limitation all text, data, graphs, charts (collectively, the “Information”) is the property of MSCl Inc. or its
subsidiaries (collectively, “MSCI”), or MSCI’s licensors, direct or indirect suppliers or any third party involved in making or compiling any Information (collectively, with MSCI, the“Information Contributors”) and is provided for informational purposes only. The Information may not be reproduced or redisseminated in whole or in part without prior written
permission from MSCI.

The Information may not be used to create derivative works or to verify or correct other data or information. For example (but without limitation), the Information many not be used
to create indices, databases, risk models, analytics, software, or in connection with the issuing, offering, sponsoring, managing or marketing of any securities, portfolios, financial
products or other investment vehicles utilizing or based on, linked to, tracking or otherwise derived from the Information or any other MSCI data, information, products or services.



The user of the Information assumes the entire risk of any use it may make or permit to be made of the Information. NONE OF THE INFORMATION CONTRIBUTORS MAKES ANY
EXPRESS OR IMPLIED WARRANTIES OR REPRESENTATIONS WITH RESPECT TO THE INFORMATION (OR THE RESULTS TO BE OBTAINED BY THE USE THEREOF), AND TO THE MAXIMUMEXTENT PERMITTED BY APPLICABLE LAW, EACH INFORMATION CONTRIBUTOR EXPRESSLY DISCLAIMS ALL IMPLIED WARRANTIES (INCLUDING, WITHOUT LIMITATION, ANY IMPLIEDWARRANTIES OF ORIGINALITY, ACCURACY, TIMELINESS, NON-INFRINGEMENT, COMPLETENESS, MERCHANTABILITY AND FITNESS FOR A PARTICULAR PURPOSE) WITH RESPECT TO ANY
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Without limiting any of the foregoing and to the maximum extent permitted by applicable law, in no event shall any Information Contributor have any liability regarding any of theInformation for any direct, indirect, special, punitive, consequential (including lost profits) or any other damages even if notified of the possibility of such damages. The foregoing shallnot exclude or limit any liability that may not by applicable law be excluded or limited, including without limitation (as applicable), any liability for death or personal injury to theextent that such injury results from the negligence or wilful default of itself, its servants, agents or sub-contractors.



Information containing any historical information, data or analysis should not be taken as an indication or guarantee of any future performance, analysis, forecast or prediction.

None of the Information constitutes an offer to sell (or a solicitation of an offer to buy), any security, financial product or other investment vehicle or any trading strategy.

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