Iceland’s Index Lessons

According to the IMF, Iceland’s 2008 banking collapse made it into the history books as the largest finance-driven GDP decline ever, as our guest blogger Tyler Mordy pointed out earlier this week.

By refusing to engage in a futile attempt to prop up insolvent banks, the country has also shown the rest of Europe a way forward when it comes to dealing with the aftermath of a credit bubble. While the rest of Europe carries on turning private bank debts into sovereign obligations with limited or no public debate, Iceland’s voters have twice been offered the chance, via referenda, to use taxpayers’ money to refund foreign depositors in now defunct Icelandic savings institutions. They have voted no on both occasions.

Iceland’s boom and bust is shown graphically by the history of the OMXI15 index, which rose nearly six-fold during the noughties, reaching a peak of over 9,000 points in July 2007. From that high point it lost nearly all of its value, falling by 97 percent over the next year and a half.

By late 2008, the index’s three leading constituents from earlier that year, all banks—Kaupthing, Glitnir and Landsbanki—had disappeared completely. In fact nine of the 15 stocks used to make up the equity benchmark in early 2008 were gone from the index a year later.

When Nasdaq OMX, owner of the Reykjavik stock exchange, tried to put together a constituent list for the OMXI15 for the first half of 2009, it couldn’t even find 15 suitable local stocks to include, and had to settle on 12.

Given the index’s traumatic history, it’s no surprise that the exchange gave up on the OMXI15 completely in 2009 and replaced it with a smaller, six-stock benchmark, the OMXI6, which currently includes two airlines, an oil company, a food processor, a manufacturer of orthopaedics and only one bank. With Nasdaq OMX planning its first Reykjavik listing in three years this summer, there may soon be a larger list of constituents for the index compilers to choose from.

But are there any broader lessons for index investors from Iceland’s financial collapse?

First, as many have pointed out, capitalisation-weighting during market bubbles lands you with exposure to the sector that is most prone to a bust. Although Iceland was an extreme example, 89 percent of the main stock market index was in financial stocks in early 2008.

Second, liquidity screening and free float adjustments don’t provide much protection. Screening stocks for liquidity prior to ranking them by market capitalisation is a commonly used way of constructing indices for investment purposes, but in Iceland’s case the most traded stocks were also the most bubbled-up prior to the collapse. Large (50 percent-plus) free float adjustments to the top four stocks in the index in early 2008 (a result of Iceland’s complex web of company cross-holdings) still left you with a cumulative 75 percent exposure to those names.

Third, approaching investing via country indices is simply a bad idea. If you thought a couple of years ago that by using Iceland’s main stock market benchmark you’d be accessing the country’s primary economic sectors of fishing, geothermal energy and mining, you’d have been completely wrong.

We’ve written before about how national benchmarks may be far from representing domestic industries, with the FTSE 100 a good example. The compilers aren’t going to stop promoting such brand name country indices. It’s puzzling, though, that so much money in the European ETF market is still invested in funds tracking them.

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