Stock market reforms drive index reclassifications (or vice versa?)

We examine this question within the context of Asian markets

Passive investment management, where investors typically buy an exchange traded fund (“ETF”) that tracks a market-weighted index, has grown in popularity over the last decade.  In the US it is expected that more than half of managed equity assets will be run on a passive basis by January 2018[1].

As more investors adopt passive investment strategies, the power wielded by index providers is increasing.  These “low-cost” strategies are often described as the curse of the active manager because they distort markets; however the truth can be more nuanced and for those of us working in emerging and frontier markets indexation can present us with opportunities.

For MSCI, the largest index provider, the world is divided neatly into developed, emerging and frontier markets.  Working with the exchanges and regulators of each country, the benchmark provider operates a rule-based system to categorise global equity markets, with a focus on (but not limited to) foreign access, liquidity, free-float adjustments and capital controls.  Consultation is continuous, but reclassifications are implemented on a semi-annual basis.

The reclassifications are important as changes don’t just track markets, they move them.  For example in 2014 when MSCI announced that Qatar and UAE would be upgraded to emerging market status from frontier, the markets rallied by 54% and 98%[2] respectively between the decision and implementation.  Pakistan, which was downgraded in 2008, is due to be upgraded to ‘emerging’ this month and has rallied 40% since the decision was taken.

Our interest in the process has heightened recently because we have seen the authorities in Vietnam (currently a frontier market) implement changes in a bid to qualify for a classification review.  In the last two years liquidity in the market has almost doubled, foreign ownership limits have been relaxed and in March this year foreign investors were asked by the Vietnamese regulator for their views on how to improve the trading and investment environment.  It is both encouraging and uncharacteristic to see the state authorities being so proactive.  If successful, and Vietnam is upgraded, we would expect the market to re-rate - with significant foreign buying as the USD 1.8trn that tracks the MSCI EM rebalances.

Active managers often blame over-indexation for the misallocation of capital in equity markets, a case that is strengthened in Asia where the indiscriminate buying of large and liquid stocks fails to take into account the misalignment of state and/or family interests and the interests of minority shareholders. However, the rigour of the index classification process requires engagement from the regulators and exchanges in developing markets, and provides a framework for reform which can benefit active and passive investors alike.

By Douglas Barnett

[1] Bernstein Research:  Fund management Strategy: Nearing the 50% passive milestone by Inigo Fraser-Jenkins (April 2017)

[2] Source: MSCI and Factset

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