Telecom Italia, L'Oreal SP and Allianz AG are among dozens of European companies whose shares may tu...
Telecom Italia, L'Oreal SP and Allianz AG are among dozens of European companies whose shares may tumble amid growing pressure to recalculate benchmark stock indexes to eliminate shares that cannot be bought by investors.
Many fund managers decide which stocks to own based on indices created by companies such as Dow Jones Stoxx and Morgan Stanley Capital International. Those indices are typically based on the market capitalisation of their constituents rather than the value of accessible shares, known as the free float. That is set to change, however, as index compilers acknowledge that their current method overvalues some companies. Phone companies that used to be government owned and family controlled businesses such as Bagerische Motoren Werke AG with millions of shares that never trade are likely to be among the losers.
"It's going to hit the big telecom-related shares the most," said Charles Lovejoy, a fund manager at Boston-based Batterymarch Financial Management, which has about $1bn of its $6.5bn equity portfolio invested in Europe. "The adjustment for free float definitely should be done, otherwise the indices don't provide a true reflection of what's available."
Analysts at Deutsche Bank say basing indices on free float could prompt portfolio managers to reshuffle $74bn of shares.
"Index tracking has become so important and so big that this distortion can't be ignored," said Sander Haaijer, who helps oversee E700 million ($672m) at Effectenbank Stroeve in Amsterdam. Ignoring free float "creates an imbalance that has to be corrected, and it must be done sooner rather than later.
Pension funds in the UK, Netherlands, Switzerland, Germany, France and Ireland were worth $2.3 trillion at the end of 1990, of which $700bn was tied to indices, according to Watson Wyatt Global Assets, which tracks the fund management industry. In the UK, the largest pension market with $1.6 trillion of funds, 28% are designed to mirror indices.
Index trackers have to match their ownership of a stock to its weighting in the index; if a company's weighting falls, they'll dump the stock and vice-versa. So if a company has a 2% index weighting, fund managers have to chase the stock even if only a small portion of its shares are available, driving the price up.
European phone companies could be among the biggest losers if investors retune investments to mirror index changes. Less than 45% of the stock in Deutsche Telekom, France Telecom, Telecom Italia and Sonera Oyj can be traded because other companies or governments own big blocks of shares.
Morgan Stanley's MSCI indices are the most widely used benchmarks for continental European equity investors, according to a June survey by the Gallup polling organisation. Deutsche Telekom and France Telecom are the second and third biggest components of the MSCI Euro Index, accounting for 10.1% of the indicator even though only a third of Deutsche Telekom shares and less than 40% of France Telecom can be traded.
Availability and liquidity
About $900 billion of MSCI Europe's $6.4 trillion in market cap can't be traded, and about $1 trillion of the DJ Stoxx pan-European index's $7.6 trillion because of the amount of shares that are locked away, according to HSBC Securities strategists Sharon Coombs and Robert Parkes.
The Quandt family, for example, owns almost half of BMW, which has a market capitalisation of 22 billion euros.
"As an investment manager, we've got to pay attention to investibility, availability and liquidity of securities," said John Demaine, a managing director who helps create new products at Barclays Global Investors, the world's biggest manager of indexed funds. "It becomes much more difficult to exit and enter shares without having a large market impact."
The debate about how best to compute European indices is heating up amid growing competition among index suppliers to be chosen by investors as the benchmark provider.
FTSE International started using free-float calculations for new constituents in March and plans to expand that to existing companies in June 2001. MSCI and Dow Jones have said they're considering free float calculations for companies already in their indexes, while Salomon Smith Barney has based its global equity indices on free float measurements for more than a decade.
"There's a lot of competitive pressure on indices to adjust for free floats,'' said Rick Lacaille, head of index fund managing for State Street in London. State Street, the world's second-biggest manager of index funds, manages about £450bn globally, of which £250bn is indexed.
Winners and losers
Salomon analysts have redrawn the constituents of the DJ Stoxx 50 based on free float, illustrating the likely winners and losers under the new system. Allianz's index weighting drops to 1.27% from 2.2%, Munich Re falls to 0.59% of the benchmark from 1.37% and Enel declines to 0.54% from 1.33%.
Among phone companies, Telecom Italia accounts for 0.94% in the new calculation rather than 1.95%, France Telecom drops to 1.65%from 3.99% and Deutsche Telekom's weighting slumps to 1.89% from 4.03%.
The winners include BP Amoco, up by a percentage point to 6.38%, Shell Transport, with a climb to 2.61% from 2.2% and Alcatel, rising to 2.08% from 1.64%, according to Salomon's calculations.
"We'll see winners and losers," said Achim Matzke, head of European Index Research at Commerzbank in Frankfurt. He expects technology and energy companies, which don't have big cross share holdings, to benefit, including Nokia Oyj, Siemens, BP Amoco and Total Fina.
In one example of the cost of not being included in a benchmark index, British Energy shares dropped 49% in the three months after the UK's biggest electricity generator exited the FTSE 100 index on 20 December.
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