The benchmark index for equities

Letter sent to the Ministry of Finance, 31 January 2021.

In autumn 2018, the Ministry initiated a review of the benchmark index for equities in the Government Pension Fund Global (GPFG)[1]. As part of this work, the Ministry wishes to assess whether the number of companies in the benchmark index is appropriate or should be reduced.

The fund’s benchmark index for equities is currently constructed on the basis of a global market-weighted index from FTSE Russell. The FTSE index represents the return from holding large-, mid- and small-cap stocks and as of the end of 2020 includes slightly less than 9,000 companies. The index’s market coverage is 98 percent of the market value of the listed companies in the markets included. Around 5,000 of the companies in the index are classified as small caps. These account for around 10 percent of the market value of the benchmark index for equities.

As a basis for its assessment of the number of companies in the equity index, the Ministry asked Norges Bank in its letter of 3 November 2020 to analyse and evaluate the consequences of reducing the number of companies in the index, and to consider any implications for the operational management of the fund. Norges Bank was also asked to make recommendations for how the number of companies might be reduced, including what might be an appropriate reduction in market coverage, and to consider other adjustments to the benchmark that might facilitate cost-effective management of the fund. One of the matters previously raised in the review of the benchmark index for equities is the possibility of switching index provider.[2]The Ministry therefore requested that the recommendations include benchmarks based on indices from both FTSE and MSCI.

A benchmark index with fewer companies

The principle of diversification is an important starting point for the investment strategy of the GPFG.[1] This was one of the arguments used when small caps were first included in the benchmark index for equities in 2007. In its assessment, the Ministry noted that this expansion of the benchmark could improve the return-risk trade-off through diversification gains and the potential for higher returns.[2] At the same time, the Ministry emphasised that having a large number of small caps in the index could result in increased complexity and costs in other areas. In its letter of 3 November 2020, the Ministry notes that the GPFG’s market value has grown considerably since 2007, and that liquidity has decreased in many equity markets. Against this background, Norges Bank was asked to consider the number of companies in the benchmark index.

Return and risk
We have assumed in our calculations that the Ministry plans to retain a substantial portion of the small-cap universe by continuing to have an index that largely reflects the investment opportunities in the listed equity market. We have therefore only considered alternative benchmarks with a slightly lower market coverage than the current 98 percent. For illustrative purposes, however, we also present a benchmark without small caps.[3]

As requested by the Ministry, the calculations have been performed for broad equity indices from both MSCI and FTSE. The two indices are fairly similar but differ somewhat in which stocks are included and which weight they are given.[4] The index from FTSE contains almost 8,800 companies, whereas the index from MSCI contains around 8,500 companies, when adjusted for ethically motivated exclusions. With 95 percent market coverage, the indices contain 5,300 and 6,000 companies respectively.

Other than the number of companies, there are only marginal differences between the current benchmark index and indices with a lower market coverage, based on data from both FTSE and MSCI. Our analyses show that the benchmark’s historical return and risk characteristics would have been little affected by reducing the number of companies to the extent considered in this letter. The same applies to the benchmark’s sector and country composition. [5]

Costs
To serve as a long-term yardstick for the choices made in the management of the fund, the equity benchmark index has been composed in such a way that it can be followed closely and at low cost. In its letter of 3 November 2020, the Ministry notes that the management of small-cap stocks is relatively more expensive than for larger companies. This is due particularly to small caps moving in and out of the index more frequently, but also to the cost of each transaction being higher for these stocks.

We find that ongoing transaction costs in the benchmark index may be slightly lower than today if market coverage is reduced to 97 percent. If market coverage is reduced further, our analyses show that ongoing transaction costs in the benchmark index increase somewhat. It should be noted, however, that the differences in transaction costs are relatively small, and that these calculations are associated with uncertainty.[6]

If the number of companies in the benchmark index is reduced, this will result in one-time costs both for selling the stocks of these companies and for buying more of the other stocks in the index. The more companies removed from the index, the higher these costs. There will also be one-time costs if the Ministry opts to switch index provider from FTSE to MSCI. The total one-time costs for reducing the number of companies in the benchmark index and switching index provider will, however, be lower if the changes are made simultaneously rather than separately.[7]

Our estimates of expected costs in the enclosure have been calculated using our model for transaction costs. Model-based calculations of this kind are uncertain, and the results must be interpreted with caution. The model we have used does not, for example, take account of the possibility of other changes to the index or the portfolio during the transition helping reduce the transaction volume significantly. The costs estimated in the enclosure must therefore be seen as an upper bound for the expected cost.[8] The actual costs incurred will depend on market developments and may differ considerably from the expected cost. We would report these costs after the completion of the transition.

Consequences for the management of the fund

The fund may be invested in any shares listed on a regulated and recognised marketplace, and currently has holdings in more than 1,000 companies that are not part of the benchmark index. We assume that a benchmark with reduced market coverage will not result in changes to the fund’s investment universe.

It is reasonable to assume that an index with fewer companies will eventually be reflected in the portfolio, even with an unchanged investment universe. This applies above all to the part of the portfolio that is managed internally. Around 80 percent of the fund’s investments in small caps are managed internally under an enhanced indexing strategy. There is therefore reason to expect the portfolio to change when the index changes.

The fund’s other investments in small caps are managed externally. External managers manage the bulk of the fund’s small-cap investments in emerging markets and around 10 percent of those in developed markets. The fund’s external managers pursue active strategies and will probably not alter their portfolios greatly if the number of companies in the benchmark index is reduced.

We have previously found that changes to one or more of the index rules can have unintended consequences.[9] A reduction in the number of companies in the benchmark would be a step away from the index provider’s standard product. A standard index product is subject to additional quality assurance in that other investors follow the index. The operational risk from using a bespoke index will probably be somewhat higher than from using the standard product. It is difficult to gain a full overview of the extent of challenges of this kind before the new index is in use. We believe these potential challenges will be manageable.   

Standard index products include regular communication with users, enabling them to be tracked closely. In our day-to-day management of the fund, for example, we rely on products from FTSE that give us visibility on upcoming changes. This helps us manage the fund cost-effectively. If the benchmark index no longer follows the standard rules, it is important that the index provider can offer a product of equal quality tailored to the index defined by the Ministry. This will contribute to continued cost-effective management.

Following an index produced specially for the fund may also have advantages in our management of the fund. Having different cut-offs for when companies enter and exit the index may reduce ongoing transaction costs for following the index.[10] The buffers for inclusion and exclusion could potentially be wider in a bespoke index, which could reduce ongoing transaction costs. In addition, there could be advantages associated with rebalancing at other times than the flagship index.

Responsible investment

The Bank seeks to promote well-functioning markets and good corporate governance. Voting is one of the most important tools we have for exercising our ownership rights. We have drawn up voting guidelines to provide a basis for the way we vote, and this has enabled us to automate around 85 percent of our voting. A further 14 percent of our voting decisions concern our largest investments and are handled manually, often in consultation with portfolio managers. Only 1 percent of voting decisions require special consideration, and a reduction in the number of companies in the benchmark index would lead to somewhat fewer cases needing to be assessed individually. All in all, however, a reduction in the number of companies in the benchmark index would not result in a significant reduction in the resources required.

Having fewer companies in the benchmark index would increase the fund’s average holding and voting rights in the companies in the portfolio, although the increase would be relatively modest.

We engage in regular dialogue with the companies the fund is invested in. In this work, we prioritise our largest investments and companies with little or no reporting on sustainability. We also follow up specific incidents and companies related to environmental, social and governance risks. Generally speaking, less information is available on small companies than on larger companies. Based on our activities in recent years, we have assessed whether this work would be affected by a decision to reduce the number of companies in the benchmark index. We find that the number of company meetings would not decrease to any great extent, but the amount of written communication would fall somewhat.

We have not assessed the consequences for the work of the Council on Ethics.[11] The Council issues recommendations on the observation and exclusion of companies in the fund’s portfolio. A reduction in the number of companies in the fund’s benchmark index would therefore affect the Council’s work only if this reduction is reflected in the portfolio. In emerging markets, the portfolio would probably not be greatly affected if the number of companies in the benchmark is reduced.

Recommendation 

There is a broad consensus that the reduction in risk that an investor can achieve by expanding the number of stocks in a portfolio will decrease as the number of stocks increases. In keeping with this, we find in a historical analysis that the benchmark index’s return and risk characteristics are little affected by reducing the number of companies to the extent considered in this letter. The analysis also shows that the cost of following the index closely is little affected by such a reduction. Furthermore, we find that a reduction in the number of companies to the extent considered in this letter does not greatly decrease the resources required for our ownership work. Going forward, if our ownership work was structured differently, the potential resource savings from investing in fewer companies could become larger.  

Any reduction in the number of companies in the benchmark index will result in one-time costs and should therefore be implemented gradually to minimise these costs. The same applies if the Ministry decides to switch index provider from FTSE to MSCI. The one-time costs for such a switch will be greater than the one-time costs for reducing the number of companies in the index. If the Ministry decides to make both of these changes, the total one-time costs may be lower if the changes are made simultaneously rather than separately.

Operationally, there is nothing to prevent the fund from being managed on the basis of an equity index with fewer constituents or based on a different index provider. It is not possible at this time for us to have a full overview of the possible operational challenges that might arise with a transition to a new and more bespoke benchmark index, but we anticipate that they could be overcome. We assume that Norges Bank would be involved at an early stage in the planning process for how such a potential transition should be implemented.

Yours faithfully,


Øystein Olsen                                                                                        Nicolai Tangen

 

Enclosure available in the pdf version.

[1] See the Ministry's letter of 6 November 2018 and the Bank's reply of 21 August 2019.

[2] See the Ministry's letter of 6 November 2018.

[3] See Report to the Storting No. 32 (2019-2020).

[4] See Report to the Storting No. 24 (2006-2007).

[5] See part 1 of the enclosure for an overview of the Bank's calculations.

[6] The difference between MSCI and FTSE is a result of the former targeting 99 percent market coverage at country level, and the latter targeting 98 percent market coverage at regional level. There are also some minor differences in which markets are included.

[7] Sector and country exposure to small caps will change slightly, with more technology and health care stocks and fewer financial and industrial stocks.

[8] See Part 2 of the enclosure for the Bank's calculations.

[9] The calculations in the enclosure are based on a benchmark index with new regional weights. These have not yet been implemented. It would be possible to reduce the total one-time costs slightly further if all possible changes to the benchmark index are made at the same time.

[10] The costs in the portfolio will probably also be lower in emerging markets than calculated, because we anticipate smaller portfolio changes there. See Part 3 of the enclosure for the Bank's calculations.

[11] See the Bank’s letter to the Ministry of 28 August 2020.

[12] See Part 3 of the enclosure for the Bank's calculations.

[13] The Ministry of Finance has in a letter to the Council of Ethics of 13 January 2021 asked the Council of Ethics to assess the consequences of a potential reduction in the number of companies in the reference index for the work on observation and exclusion of companies in GPFG.

Download the letter (pdf)