Phase one of the planned two-phase transition to the "new" MSCI global index methodology took place last Friday, November 30, and investors are still sorting out who won and who lost in the massive maneuver.

The indexing giant is making a significant change to the methodology for its benchmark MSCI Global Index series, which includes such popular indexes as the MSCI EAFE and the MSCI Emerging Markets index. The change boils down to two key components:

• The "Standard" indexes will now cover only large and mid-cap stocks, but will offer more comprehensive coverage of that space; in the past, they covered a smattering of small-cap stocks as well.
• MSCI will launch a separate and comprehensive Small Cap index series, which will be distinct from the standard series.

Net-net, the new MSCI indexes will cover 99% of the world's market cap, compared with just 85% before the change.

The decision by MSCI to launch small-cap indexes shows that investors are moving more and more to embrace those markets. Investors have turned to small-cap international in search of noncorrelated returns, as large-cap international markets have been increasingly trading in similar patterns.

However, the fact that MSCI is walling off small-cap away from its "Standard" index series suggests that most investors are still shying away from these markets in their broad international investments, perhaps for fear of liquidity issues.

Popular MSCI-linked index funds like the iShares MSCI EAFE ETF (EFA) will mostly track the "Standard" index series, which means they will sell the old small-cap components and buy the added mid- and large-cap components.

As with any major index rebalance, the capital flows from funds tracking these benchmarks were large, and traders reported seeing significant buying pressure at the close of last week. To minimize the potential market impact, MSCI is making the transition in two rounds: half the market cap moved on November 30, 2007, and half will move on May 30, 2008.

For a firsthand examination of the changes, check out this Journal of Indexes interview with MSCI CEO Henry Fernandez.