'Hong Kong Exchanges and Clearing chief executive Paul Chow has attributed the sudden surge in transaction volume and price movement on May 30 to the MSCI rebalancing. Mr Chow told the media today more than 95 per cent of turnover value during Friday's closing auction session came from the 167 stocks affected by the rebalancing, resulting in at least HK$30 billion in fund flow from passive funds tracking the relevant MSCI indices.' Government news release, June 2 Mr Chow could have expressed it differently, of course. He could have admitted that a fancy new system for establishing closing prices on the exchange came badly unstuck within a week of being introduced, with the result that those prices bounced wildly up and down, exactly what the system aimed to prevent. But he wants to keep the closing auction system. Admitting that it went off the rails on its first real trip out of the station wouldn't have contributed to this objective and thus he tried to say it was the fault of an MSCI rebalancing. How ironic that attempts to refine the natural workings of a market so as to make them fairer often just make them cruder. The lesson here has to be that you can't beat the unadorned plain-vanilla bid-and-offer system for efficiency. It works. Let me explain MSCI rebalancing first, however. MSCI stands for Morgan Stanley Capital International and the acronym refers to market indices by which fund managers can measure the relative performance of the investments they have made. There are a large number of these indices for individual stock markets and for regional groups of stock markets. They also have many permutations covering such things as inclusion or exclusion of dividends and the choice of reporting currency. Their big selling point is that they are constructed in the same way around the world and thus can be truly international benchmarks of performance. But they can be very humiliating benchmarks, too. Only a small minority of active fund managers ever do as well as the MSCI indices against which they are measured. They don't like to admit this but it's true. There is a way of evading this embarrassment, however. Instead of measuring your performance against the index, you can use it to dictate your performance. Just buy the stocks in an MSCI index in exactly the proportion in which they comprise that index and you will do just as well as the index, thus outperforming most fund managers. You still have to deduct your own costs of course but you can always fudge this when reporting to your clients and, in any case, your costs need not be high. You no longer need an army of analysts and dealers. Most big funds are now such indexed funds. They are either professedly so or they have lying managers who demand a fee for active investing when they are actually passive index investors. Often they can't help it. Big funds are by nature pretty close to being indexed funds. They buy the big stocks and the big stocks are in the index. But every now and then these component stocks must be changed if the indices are to continue to be representative of their markets. New stocks come on the markets and others fade away. This is called rebalancing and we had one of these rebalancings at the end of last month in MSCI indices of the Hong Kong market. Immediately all the indexed funds had to buy the stocks coming into the indices and sell the ones being dropped or they would risk tracking errors, which is a sin for indexed funds. Meanwhile, HKEx had adopted the closing auction, a 10-minute period at the end of each trading day where all outstanding orders are matched at an 'indicative equilibrium price' determined by a bit of fancy maths. The idea was to stop market manipulators from pushing stock prices artificially up or down at the close to create false impressions of demand. Now, back when I was in the stockbroking business no one got particularly bothered about artificial closings. They didn't fool many people, they often backfired and they could never make you more than pocket change anyway. But regulators are easily offended and the practice is now considered a big crime. The difficulty, however, is that the managers of indexed funds came to the view last week that the new 10-minute trading period was ideal for adjusting their positions in line with rebalancing the MSCI indices. The result was an enormous volume of trading and prices that went hugely awry for the simple reason that it was computers that determined what the newfangled indicative equilibrium price would be and the phrase 'Hey, this is stupid' does not compute. So now we have Paul Chow scrambling over himself to keep his closing auction system, the clincher argument now being the lemming one that everyone else does it and so we have to do it too, even if it is likely to produce a big mess again, which it is. How dearly I wish sometimes that these overly moralistic regulators who afflict us would go back to Australia and leave the Hong Kong market to run as it naturally runs best.