The blind spots of indexing

The Blind spots of indexing

The MSCI indices are market cap weighted indices, which means that stocks are weighted according to their market capitalization, calculated as stock price multiplied by total number of shares outstanding. Therefore, the stock with the largest market capitalization gets the highest weighting on the index. This reflects the fact that large-cap companies have a bigger impact on an economy than mid- or small-cap companies. A percent change in the price of the large cap stocks in an MSCI index will lead to a bigger movement in the index than a change in the price of a small-cap company.

Each index in the MSCI family is reviewed quarterly and rebalanced twice a year. Stocks are added or removed from an index by analysts within MSCI Inc. to ensure that the index still acts as an effective equity benchmark for the market it represents. When an MSCI index is rebalanced, ETFs and mutual funds must also adjust their fund holdings since they are created to mirror the performance of the indices. 

Trading in the shares of marble miner ArtGo Holdings was halted on Thursday after they crashed 98%, erasing all of their gains over the past year and more, following index compiler MSCI's decision to reverse a planned inclusion in its equity benchmarks.

The sharp moves followed a statement Wednesday by MSCI that contrary to its announcement on Nov. 7, the index compiler will not be adding ArtGo shares to its benchmarks as it had intended to with effect from Nov. 27, as part of a semi-annual index review. The decision followed "further analysis and feedback from market participants on investability," MSCI said.

Thursday's collapse follows a period of superlative gains, which saw ArtGo's shares surge more than 3,700% over the past year. The stock had more than doubled in value from its closing price of HK$6.50 on Nov. 7 through Wednesday, following MSCI's plan to include the company in its indexes.

Initial thoughts
Despite the effectiveness of index funds for individual investors in maintaining long term long position in a low cost manner, it is interesting how indexing can evolve from being a passive (wrapper) to actively influencing stock prices. 

My first encounter into Art go is not from the online newsletter, but from an unsolicited Wechat request by a stranger. The uncanny friendliness and the talking up of the stock regardless of fundamentals triggered my bullshit detection senses, and I blocked her immediately after I suspected that she is trying to rope me into a pump and dump scheme. This incident left my mind until this stock reappeared in the recent online articles, about how the prospect of indexing can drive speculators to pursue (arbitrage opportunities), whereby rumoured inclusion in an index can drive up the price regardless of fundamentals. If not for active watchdogs, blind investing based on market cap methodology can choose stocks that are sufficiently large, regardless of their financials or fraudulent ways to attain that. Follow up blind buying from investors in index funds in turn actualize the story about the perceived market value. 

For passive index investing, Due Diligence is outsourced to active investors. Although a single article may be inconclusive, it is bewildering and a symptom of the times we are in. The dominance of passive over active investments can actively shape market expectations. 



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