Equity-Market Dislocation and Index-Based Investing

Blog post
Shuo Xu, Zhen Wei
June 3, 2020
  • During turbulent market environments, dislocations may sometimes happen in equity markets and market segments, including geographies, market-cap size and sectors.
  • Index-level prices, along with fundamental data, could help investors identify potential dislocations in market performance.
  • Currency-hedged indexes could help identify potential dislocations in a strategic currency-overlay policy.
During periods of heightened volatility, indexes with up-to-date constituent composition, may help identify potential dislocations in global and regional equity markets, as well as various market segments, including sectors and market capitalization.
Index-Level Fundamental Data and Exploring Potential Market Dislocations
An example of potential dislocation was reflected in the high degree of performance dispersion across various market segments for the year to date through May 29, 2020. The exhibit below shows that, based on gross index returns, while the Chinese equity markets (benchmarked to the MSCI China A Onshore IMI Index and MSCI China IMI Index) performed the best year to date among major equity markets, they underperformed global equities (benchmarked to the MSCI ACWI IMI Index) during the past 10 years.
Comparing Short- and Long-Term Market Performance
Performance and valuations (%)

None

1D

1W

1M

3M

MYD

QTD

YTD

1 Yr

3 Yr

5 Yr

10 Yr

MSCI China A Onshore IMI Index

0.8

1.5

-1.0

-3.2

-1.0

5.2

-3.6

5.6

-1.6

-10.4

3.5

MSCI China IMI Index

1.5

2.3

-0.6

-1.4

-0.6

5.7

-5.2

11.3

5.6

1.5

5.5

MSCI USA IMI Index

0.5

3.1

5.4

3.0

5.4

19.4

-5.6

10.3

9.5

9.2

12.9

MSCI Japan IMI Index

-09

5.6

6.2

4.4

6.2

12.1

-7.2

6.1

3.7

3.9

6.5

MSCI World IMI Index

0.0

3.8

5.1

0.5

5.1

17.0

-8.8

5.3

5.9

6.1

9.8

MSCI ACWI IMI Index

0.0

3.7

4.7

-0.4

4.7

16.2

-9.7

4.2

5.2

5.5

9.0

MSCI EM Asia IMI Index

1.0

2.7

-0.1

-4.0

-0.1

9.6

-11.1

3.0

1.4

1.9

5.2

MSCI AC Asia ex Japan IMI Index

0.8

2.4

-0.9

-5.3

-0.9

8.5

-12.2

-0.3

0.9

1.4

5.2

MSCI EAFE IMI Index

-0.9

5.2

4.8

-3.3

4.8

12.2

-14.0

-2.7

0.3

1.6

6.0

MSCI World Small Cap Index

-0.1

4.4

7.1

-3.6

7.1

21.5

-14.9

-2.7

2.0

4.0

9.1

MSCI USA Cap Index

-0.2

3.6

7.2

-4.8

7.2

23.1

-15.4

-4.3

3.1

4.6

10.4

MSCI Europe IMI Index

-0.8

5.3

4.9

-5.1

4.9

12.0

-16.1

-4.1

-1.0

0.9

6.1

MSCI EM IMI Index

0.5

2.8

0.9

-7.2

0.9

10.7

-16.3

-3.7

-0.6

0.7

2.8

MSCI FM IMI Index

0.3

2.6

5.3

-12.0

5.3

12.4

-16.9

-11.8

-3.4

-0.4

None

MSCI Europe Small Cap Index

0.0

6.6

6.9

-6.5

6.9

18.9

-17.3

-2.6

-0.9

2.7

9.0

MSCI EM Small Cap Index

-0.1

2.6

2.4

-10.2

2.4

16.7

-19.9

-11.7

-5.0

-3.7

1.4

MSCI EMEA IMI Index

-1.5

1.3

3.6

-9.6

3.6

15.0

-24.1

-14.7

-5.7

-2.8

-0.7

MSCI EM Latin America IMI Index

-0.9

6.5

6.4

-26.8

6.4

13.5

-39.0

-30.3

-8.5

-3.6

-4.1

Gross returns in USD for the period ended May 29, 2020. Returns are annualized for periods longer than one year. Valuation ratios are as of end of month, adjusted by month-to-date returns.
In such a context, fundamental data such as dividend yield, earnings growth, return on equity, leverage, price-to-earnings ratio and other profitability/valuation metrics could provide important information when evaluating how the global market and its segments stand in absolute and relative terms. The exhibit below shows that after the global-market sell-off during Q1 2020, the global equity market was valued below its historical mean in terms of price-to-12-month-forward-earnings ratio, as of March 31, 2020. However, this valuation metric wasn't extremely low compared to its history.
Index Valuations Across Market Segments
Based on MSCI data from December 2002 through March 2020. Current is as of March 31, 2020.
Looking to Regions, Market-Cap Size and Sectors
Fundamental data could help provide further information about potential dislocations in relative positionings. For example, based on index-level price-to-forward-earnings ratio, North America was valued around its historical average at the end of Q1 2020. The region's valuation was expensive relative to the Pacific region, however, at 90% of its historical percentile. Similarly, the same indicator pointed to potential undervaluation of global small caps relative to large caps, as well as the financials sector relative to communication services at the end of Q1 2020, as shown in the exhibit below.
Historical Relative Price-to-12-Month-Forward-Earnings Ratios
Scouting for Potential Dislocation in Currency-Overlay Policy
With policy rate cuts across major economies and a flight to safe-haven currencies during the COVID-19 outbreak, the return and risk impact of existing currency-overlay policy might have been affected, potentially creating a misalignment between policy and the macroeconomic environment. We looked at the effect of currency hedging in international portfolios based on MSCI hedged indexes. Over the first quarter of 2020, U.S.- and Japan-based investors would have gained by fully hedging their international currency exposures due to the appreciation of their domestic currencies. On the other hand, Australia-based investors who fully hedged, statically, would have seen a reduction in return and a rise in risk over the same period. As we've seen in prior research, a more adaptive approach to currency hedging could serve as an alternative method.
Effect of Currency Hedging During COVID-19: The Local Investor's Perspective
Long-term period: December 2001 through March 2020. Active return/risk difference is the difference between annualized or Q1 2020 return/risk of the currency-hedged index and respective parent index. The currency-hedged indexes include the MSCI World ex USA Index hedged to USD, MSCI World ex Japan Index hedged to JPY, MSCI World ex UK Index hedged to GBP, MSCI World ex Australia Index hedged to AUD and MSCI World ex Europe Index hedged to EUR. Return and risk figures were calculated based on investors' local currencies; e.g., JPY is used for the MSCI World ex Japan Index's return calculation.
Market turbulence amid the COVID-19 crisis might have presented risks and opportunities for investors due to short-term dislocation of financial markets and market segments. During such a time, indexes, combined with an exploration of fundamental data, provided a wealth of information to help identify potential market dislocations.
Further Reading
Outcome-Oriented Factor Investing with a 'Barbell' Approach Index Rebalancing During High Volatility: A Balancing Act Asset allocation and index futures during market crises Bond ETFs and underlying price uncertainty Currency Hedging: Adapting to Volatility
Shuo Xu
Shuo Xu
Executive Director, MSCI Research
Zhen Wei
Zhen Wei
Managing Director, MSCI Research

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