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Mukul Munish

A move by Morgan Stanley Capital International (MSCI) to change its Emerging Market Free Stock indices to a free float could send prices of local blue chips into a tailspin in the week ahead.

MSCI is expected to alter its stock market portfolio today by using the calculation method of a free float. Stocks are presently weighted on the basis of market capitalisation.

A free-float system would weight stocks according to the number of shares actually available for open trade, rather than according to the stakes held by governments or non-listed companies. MSCI and FTSE International are the most widely used benchmarks for international equity investment, with FTSE already using a free-float system.

It is the first time that MSCI has considered such a dramatic change, and analysts have voiced concern over the effects such a system could have on the Hang Seng Index.

Alan Hutcheson, an analyst at Pacific Challenge Securities, expects Hong Kong to suffer more than some other Asian markets.

'The Hong Kong market free float is 50 per cent, which is a lot lower that other big developed markets,' Mr Hutcheson said.

'The Hang Seng could face some rough weather in the short-term,' said a regional strategist.

As a number of funds use MSCI as a benchmark for their portfolios, the change is likely to result in stocks with less free float being sold off. These include companies such as China Mobile, which has a 25 per cent free float, Cathay Pacific, with a 29 per cent figure and the beleaguered Pacific Century CyberWorks, which offers only 39 per cent of its shares for open trade.

ING Barings chief strategist Markus Rosgen, expects certain companies to face the threat of falling by the wayside.

'The biggest losers among Hong Kong's 50 largest companies will be China Mobile, Hutchison [Whampoa] and Hang Seng Bank,' said Mr Rosgen.

Yesterday, both CyberWorks and Hutchison declined to comment on the possible effects of being reweighted in the MSCI index.

Dresdner Kleinwort Benson Asia strategist Sean Darby believes Hong Kong corporations will suffer less than their counterparts in other Asian countries, but expects a degree of volatility.

'Essentially, fund managers will look at big stocks,' said Mr Darby. 'In Hong Kong the only company which we expect to really be adversely affected is Hang Seng Bank.'

Opinion is split over whether MSCI should make the changes at all. Mr Rosgen supports the move, arguing that it presents a more realistic picture of the market.

'A free-float system is much more realistic - it removes some of the anomalies,' said Mr Rosgen, citing examples where companies with only a 5 per cent free float were treated as being 100 per cent listed.

Mr Hutcheson, however, argued that there was little wrong with the status quo. There are a number of reasons to support his point of view.

Market capitalisation can be measured objectively. Additionally, the exact definition of 'float' can vary, leading to a situation where markets with higher standards of market disclosure are unduly penalised.

Fund manager Kingston Lee, assistant director of Schroders, hopes the changes will be final.

'I would hope that the mechanism will be transparent and there will be no further changes,' he said.

Supporters of the change believe the long-term effects will be beneficial for the Hong Kong market. Companies looking to raise equity capital will be forced to make more shares available for public ownership.

'It is a bit of a wake-up call for a lot of the family holdings,' said Mr Rosgen. 'It should create a more widely held stock.'

A key factor is whether the changes will be made over a period of time or with immediate effect. If the indices are altered 'overnight' analysts fear the worst, with fund managers having to rapidly restructure their portfolios. Passive funds, which track MSCI's indices, would be cornered into buying and selling the same shares, leading to significant price distortion and huge transaction costs.

Mr Hutcheson said: 'If people are going to do it overnight it will be a nightmare.'

Mr Darby also expects more activity if changes are made in a one-day 'big bang'. 'I see quite a bit of activity if the changes are not phased in,' he said.

Due to the effects of a sudden change, analysts have predicted the changes will be phased in.

'The changes will have to be staggered over time,' said Mr Rosgen.

Under-performance by passive funds is widely expected.

However, Hong Kong's best known passive fund, the Tracker Fund is not predicted to suffer as it is linked to the Hang Seng Index and not to an MSCI index.

The Hong Kong companies expected to benefit most from the changes are HSBC, which has a 100 per cent free float, and Bank of East Asia, which has 90 per cent freely available.

Asia will be hit the hardest by the changes, due to the lower percentages of free float for the continent, with Indian and Malaysian stock markets hit hardest.

In a regional context, Hong Kong will not do too badly. Mr Rosgen expects a decline of one percentage point.

However, Asia's weighting in the Emerging Markets Free Index would fall to 40.2 per cent under a pure free float, from 46.5 per cent presently.

Uncertainty also surrounds the exact changes MSCI might make. It could, for instance, make only a partial change or it could opt for a pure free float.

MSCI managers remain quiet about the changes and have delayed comments on the process until after the announcement.



Analysts fear Asia's blue chips will be hit hardest after benchmark stock weighting is altered