Two Greater China indices launched by MSCI this month may leave lethargic fund managers quaking in their Guccis. The two new indices, Zhong Hua and Golden Dragon, are both calculated with dividends reinvested. That means the true performance of their fund managers can be judged.

For example, the average yield from dividends reinvested of all the stocks in Hong Kong's Hang Seng Index is 2.8%. As the Hang Seng doesn't take dividend reinvestment into account, investors could easily be misled in attributing that 2.8% 'growth' to their fund manager's performance. However, the manager may have done little more than to reinvest the dividends. Of course, few managers would care to draw their clients' attention to this point.

Cans of worms opened?

MSCI Golden Dragon, which tracks the Greater China market, is 17.5% weighted on China, 37.9% on Taiwan, and 44.5% on Hong Kong. Zhong Hua, on the other hand, gives one-third of its weightings to China stocks and the rest to Hong Kong's. While it remains to be seen whether Golden Dragon and Zhong Hua will prove as popular with institutional investors as another MSCI regional index, Far East Free ex-Japan, they could cause institutional money to shun local indices.

Executive Director of MSCI John Fildes argues that the Hang Seng, for example, is no longer a relevant investment benchmark for institutional investors. "If you look at institutional money invested in Hong Kong, it's not tracking the Hang Seng, it's tracking the MSCI HK," he says.

Fildes claims that 50% of the Hang Seng's market cap is comprised from companies that are not even Hong Kong stocks. "HSBC to us is a British bank and is in our UK index. China Telecom, which we view as a China company, is in our China index. So to a global investor who has to allocate money across borders, these domestic indices are useless," he says.

Fildes suggests the investment community is now moving away from single country indices produced by single country operators. "The world is moving much more to cross-border investment, which means it's international indices that they'll be looking at," he says.

Time to ditch the 10/40 rule?

If single country indices are becoming irrelevant, then investment constraints placed on mutual funds are also looking antiquated, such as the 10/40 rule.

The 10/40 rule, which applies to many European and US-domiciled funds, prevents fund managers from investing more than 10% of a portfolio in one stock. The managers are also prohibited from having more than 40% of the fund's holdings vested with a group of companies that accounts for less than 5% of the total number of stocks.

The top 10 places in the Golden Dragon Index are dominated by telecommunications, media and technology (TMT) stocks. China Telecom, the second-largest constituent after Hutchison Whampoa, accounts for more than 10% of the index even though 60% of its market value has been discounted. Others prominent stocks include Taiwan Semiconductor Manufacturing Corporation, United Microelectronics, Cable & Wireless and Pacific Century CyberWorks.

The problem with a regional index that has such a high exposure to a particular stock or sector is that fund managers can easily breach constraints, such as the 10/40 rule, on how much they can hold in a sector or a stock.

Finland presents an extreme example of this problem. Nokia represents about 70% of the Finish market. Would any manager want to underweight Nokia?

"As an index provider we continue to look at this type of situation to see whether we should be changing our methodology to constrain the weight of a single stock," says Fildes. "But it's very difficult to do that without damaging the performance of the index, and the index is really there to reflect the performance of the overall market. I think what you have to question is whether in today's world these constraints themselves are realistic."

In short, if fund managers are restricted by investment constraints, outperforming the index becomes more difficult. That partly explains why managers with investment constraints take non-performance-based flat fees, while managers who seek absolute returns charge for performance.

Fildes says that one of the main problems in creating a China index is how to define what exactly are Chinese stocks. The Chinese stocks included in Golden Dragon and Zhong Hua are predominately red chips, H shares and a small number of B shares. Fildes says that N shares, premium Chinese companies listed on the New York Stock Exchange, may be included in the future.