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Heather Apperson, Senior Portfolio Strategist, Global Equity Beta Solutions
Marquee emerging market indices are broadening, giving investors access to several markets that were previously hard to access.
China is increasingly becoming more relevant and influential in an EM beta allocation.
This year and into 2020, a number of structural changes are being made to emerging market (EM) indices offered by MSCI, FTSE/ Russell and S&P Dow Jones. While country changes are more common in EM than in developed markets, the announced changes related to China, Saudi Arabia, Argentina and Kuwait differ in few ways. First, they are grander in scale, and second, they significantly alter the mix of markets EM investors are exposed to in the future. A table detailing country-specific EM index changes appears in the Appendix.
Scale of EM Index Changes
The May 2019 MSCI rebalance was the most significant EM index rebalance in history. Year-to-date two-way turnover following the August rebalance was 9.11%, which is greater than the average annual turnover over the last 10 years.1 Given that an estimated $1.9 trillion in assets are benchmarked against the MSCI EM index, this was a significant event from a trading perspective.
Additional China A Exposure
The introduction of domestic China A-shares into mainstream equity indices last year, as well as an increase in MSCI’s assumed inclusion factor this year, underscore the growing influence and relevance China has in an overall EM beta allocation. In September the Chinese government also announced future plans to abolish investment quota restrictions for qualified foreign investors, pointing to the likelihood that index inclusion factors might rise in the future.2 If the inclusion factor reaches 100%, China could represent more than 40% of EM indices (see Figure 1).
Some investors have expressed concerns about the current weight of China in EM indices. Recent conversations with institutional investors have included conflicting views: e.g., (1) that the current allocation to China from a market-cap-weighted EM index perspective is low relative to a 100%-inclusion-factor assumption and (2) that EM in general is becoming too China- or Asia-centric. The way forward may mean that institutional investors may choose to adjust future private or public allocations to China, treating them as standalone allocations similar to investments in the US. Furthermore, the prevalence of state-owned enterprises, divergence in corporate governance practices relative to other EM peers and general skepticism of Chinese economic data may be other factors that weigh into investors assessing China on standalone basis.
New Markets: Saudi Arabia and Argentina
In a way, the promotion of Saudi Arabia and Argentina into EM indices embodies what it means to invest in an “emerging asset class,” although as with any new EM entrants each market comes with its own risks and nuances.
Saudi Arabia, once accessible only to neighboring Gulf Cooperation Council countries, is arguably one of the last major markets to open its doors to foreign investors in this lifetime. The anticipation leading up to the inclusion of Saudi Arabia was evident both from a valuation and market volume perspective.
Notional trading volume in both the May and August 2019 MSCI rebalances was around $7.7 billion in each tranche. Yet the bulk of the trading volume, particularly in August, was driven by index managers–suggesting that valuations are less attractive to active managers. Nevertheless, in due course, EM index investors will have increased exposure to Saudi Arabia once Saudi Aramco, the world’s largest oil producer, IPOs. This comes at an unusual time for those investors, particularly in Europe, that are keenly focused on climate change and carbon reduction strategies.
Argentina, which has toggled between MSCI’s Frontier and Emerging Market status in the past, had recently made notable improvements to its capital market structure and was re-promoted to EM status. The promotion came as a surprise to some market participants because of past and present economic and political instability and uncertainty surrounding the forthcoming presidential election. In September, one month after being formally added back the MSCI EM Index, the Argentinian government reinstated capital controls for local investors as well as other restrictive capital market measures. While ADRs and GDRs are the primary way foreign investors gain access to Argentinian equities, issues surrounding dividend repatriation could present challenges to index replicability. It remains to be seen whether MSCI will reverse its decision but, for now, they are surveying market participants and plan to deliberate in mid to late December.
The changes described have implications for asset managers and investors alike. EM index managers by nature must remain aligned with indices and are thus tasked with implementing these changes, while ensuring tracking. To do this in a seamless fashion, an index manager must effectively coordinate efforts between portfolio management, research, trading, operations and other stakeholders. That said, working with a large and experienced index manager that has a global presence, like State Street Global Advisors, can help ensure optimal implementation and execution results. For active managers, the benchmarks they measure themselves against are broadening, making some previously hard-to-access markets more mainstream, potentially raising the bar. And most importantly, investors gain access to new markets, creating a different EM exposure relative to the past. With all that in mind, all parties should be mindful that even seemingly subtle index changes can ultimately impact returns over the near and long term.
1Note that average annual turnover figures include the regular, semi-annual rebalancing that takes place in November each year.
3ChiNext is a NASDAQ-style board of the Shenzhen Stock Exchange. ChiNext aims to attract innovative and fast-growing enterprises, especially high-tech firms.
ADRs: An American depositary receipt (ADR) is a certificate issued by a U.S. bank that represents shares in a foreign stock, used to trade on American stock exchanges. An American depositary receipt (ADR) is a certificate issued by a U.S. bank that represents shares in a foreign stock, used to trade on American stock exchanges.
Emerging Markets: 26 emerging economies: Argentina, Brazil, Chile, China, Colombia, Czech Republic, Egypt, Greece, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Pakistan, Peru, Philippines, Poland, Qatar, Russia, Saudi Arabia, South Africa, Taiwan, Thailand, Turkey and the United Arab Emirates.
FTSE: The Financial Times Stock Exchange Group (FTSE), also known by the nickname of “Footsie,” is an independent organization. It is similar to the Standard & Poor’s, which specializes in creating index offerings for the global financial markets. An index will represent a market segment and is a hypothetical portfolio of stock holdings.
GDRs: A global depositary receipt (GDR) is a bank certificate issued in more than one country for shares in a foreign company.
MSCI: MSCI Inc is an investment research firm that provides indices, portfolio risk and performance analytics, and governance tools to institutional investors and hedge funds.
S&P Dow Jones: S&P Dow Jones Indices, a joint venture of McGraw-Hill Financial and CME Group, offer more than 830,000 Indices, the most popular of which are the S&P 500 and the Dow Jones Industrial Average (DJIA). Most S&P Dow Jones Indices are equity based and can span across asset classes including commodity, currency, fixed-income, futures, options, private equity and other alternative asset classes. The large volume of Indices available offer solutions for all possible needs from very broad-based indexing to very specific indexing.
The views expressed in this material are the views of Heather Apperson through the period October 8, 2019 and are subject to change based on market and other conditions. This document contains certain statements that may be deemed forward looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected.
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The information provided does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor’s particular investment objectives, strategies, tax status or investment horizon. You should consult your tax and financial advisor.
Currency Risk is a form of risk that arises from the change in price of one currency against another. Whenever investors or companies have assets or business operations across national borders, they face currency risk if their positions are not hedged.
Foreign investments involve greater risks than US investments, including political and economic risks and the risk of currency fluctuations, all of which may be magnified in emerging markets.
Investments in emerging or developing markets may be more volatile and less liquid than investing in developed markets and may involve exposure to economic structures that are generally less diverse and mature and to political systems which have less stability than those of more developed countries.
Investing involves risk including the risk of loss of principal.
All the index performance results referred to are provided exclusively for comparison purposes only. It should not be assumed that they represent the performance of any particular investment.
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