In the News: 2004

Taiwan's New Heft in Indicators Could Trigger an "Index Effect'

The Wall Street Journal
26 October 2004

Hong Kong -- A BOOST IN the weighting of Taiwan in emerging-market indexes could bring new waves of capital into its stock market soon, but the euphoria may be short-lived.

Morgan Stanley Capital International announced in June a two-step process that will eventually raise Taiwan's standing in some MSCI indexes by as much as 9%. Anticipating a pop in Taiwan's stock markets, investors started pouring money into the island. But some investors remain wary.

"Around the time of the index change, the exact opposite of what you expect can happen," says Symon Parish, an equity portfolio manager at Russell Investment Group in Sydney.

The reason: index rebalancings can trigger an "index effect," a situation in which traders purchase the most heavily weighted stocks in the index in anticipation of heavy demand from mutual funds that must replicate the new benchmark. On or shortly after the day of rebalancing, when the buyers try to make a profit by selling, the market could be flooded with sell orders, damping the price of the biggest, most frequently traded stocks.

The three stocks that may see the largest trading volumes from passive fund flows are Taiwan Semiconductor Manufacturing Co., United Microelectronics Corp. and Cathay Financial Holding, according to Merrill Lynch.

In recognition of Taiwan's relaxation of foreign-investment regulations, MSCI decided to remove the market's so-called Limited Investability Factor, or LIF, a measure of openness that has discounted, or reduced, the island's weight in the widely-followed indexes. On Nov. 30, Taiwan's LIF will be raised to 75% from 55%, and on May 31 it will become 100%, meaning a discount will no longer be applied to the weighting.

Taiwan's boost in the MSCI indexes is taking place in the context of slowing demand for its exports. Economists attribute the trend to oil price increases -- which act as a tax on consumers, eventually reducing their spending power -- rising interest rates and reduced growth in major markets such as the U.S. and Europe.

Whiplash from index rebalancings isn't a new phenomenon. In May 2000, MSCI boosted Taiwan's weighting by 15%. In the six weeks prior to that move, the MSCI Taiwan index outperformed the MSCI All Country Far East ex-Japan index by 8.8%. But as fund managers gradually reduced their holdings over the following month, the MSCI Taiwan benchmark lost 12% against the regional benchmark. A similar pattern emerged during the removal of South Korea's LIF in August 1998.

"The much safer way to play it is to sit on your hands now and short the Taiwan market at the end of November," says Margaret Hartmann, an analyst with Macquarie Securities in Sydney, referring to a bet against a given stock or index. "I think the reversal effect here [in Taiwan next month] will be sharp."

MSCI's action will significantly increase Taiwan's weight in eight main indexes. For instance, the island's share in the MSCI All Country Far East ex-Japan index will be boosted by nearly 10 percentage points to 26.85%, giving it the biggest weight in that index, according to data from MSCI. (Taiwan is currently ranked third, behind Korea and Hong Kong.)

The magnitude of the so-called index effect will depend in large part on the amount of money that flows into Taiwan around the time of the rebalancing -- a figure that's hard to estimate, thanks to the many private inflows and outflows that aren't tabulated. Analysts say inflows could range between US$2 billion and $30 billion, depending on how much investors have positioned their portfolios for the move.

Brad Durham, an analyst with EmergingPortfolio.com Fund Research, says many global funds started aggressively buying Taiwanese equities in mid-2003, when the government announced it would abolish restrictions on foreign direct investment. But he admits that the fund flows that EmergingPortfolio.com track don't include all "separately managed accounts and institutional pools of capital."

Fund managers who don't have to mimic the MSCI indexes say they're not going to ride the wave of incoming money, however large or small it may be.

"We have been taking a more cautious view in the short term," says Sam Lau, fund manager for HSBC Asset Management in Hong Kong. Mr. Lau, who manages roughly $800 million in funds, expresses concern about rising oil prices, increasing interest rates, moderating growth in gross domestic product and falling market volatility.

To find winners in the process, Arik Reiss, co-head of Pacific Rim equity derivatives research at Merrill Lynch in Hong Kong, says it's best to focus on stocks that aren't frequently traded and might experience significant fund inflows and, thus, buying pressure. To find these companies, Mr. Reiss calculated the amount of money expected to flow into each stock, based on its weightings, and then divided by daily turnover.

Based on Mr. Reiss's analysis, the top three stocks that should benefit from the rebalancing are Nien Hsing Textile, a manufacturer of denim fabrics and jeans, Fu Sheng Industrial, which makes golf-club heads, and Nien Made Enterprise, a maker of window blinds and curtains. Mr. Reiss stresses that his analysis is "purely mathematical" and isn't based on fundamental credit analysis.