MSCI Classification Changes: Developed, Emerging, and Frontier Markets

Last week MSCI, a leading provider of market indices to which an estimated US$7 trillion in investments is benchmarked, announced a number of changes and forthcoming reviews in country equity market classifications. These changes will be of considerable importance to the markets involved, and several would have broader implications. The MSCI classification of markets as developed, emerging, or frontier markets determines which national markets are to be included in the respective indices. Those indices play an important role in determining and evaluating the investment strategies of institutional and individual investors.

The MSCI classification process considers the following criteria: economic development (used only for the developed versus emerging market determination), size of the market, liquidity, and market accessibility. Market accessibility involves a number of subcriteria of importance to the international investment community. The reviews clearly go deep into the regulatory structure of the markets.

Last week’s announcement included the downgrading of Greece from a developed market to an emerging market. The price decline of 83% since 2007 and resulting reduction in capitalization was only one reason for the declassification. There are also a number of market accessibility shortcomings in areas such as securities borrowing and lending facilities, short selling, and transferability. This downgrade, the first ever from the ranks of developed markets, ironically might prove to be a positive development for Greece. Its weight in the Emerging Markets Index will surely be substantially greater than its currently close-to-zero weight in the Developed Markets Index. Recall that there are large exchange-traded funds and other funds that track the MSCI Emerging Markets Index, a widely used benchmark.

The Middle East markets of Qatar and the UAE are upgraded from frontier markets to emerging markets, while the North African market of Morocco has been reclassified from an emerging market to a frontier market. The reclassification of these three markets as well as that of Greece, since they are very small markets, will not have any effect on global markets.

In contrast, three MSCI country classification reviews, one of which is new and the other two of which are ongoing, potentially could have significant effects.

The new review that was announced by MSCI is of the possible inclusion of Mainland China A-shares in the MSCI Emerging Markets Index. Currently the China portion of that index is made up of the H-shares of Chinese companies listed in Hong Kong. The Hong Kong market clearly meets the market accessibility standards; indeed, it is classified as a developed market. Despite a number of positive regulatory developments to open up the mainland A-share Shanghai and Shenzhen markets, MSCI indicates they still fall short on three counts: (1) limited capital mobility, (2) a lack of clarity on taxation rules, and (3) the lack of a mechanism “to link the size of investors and their investment processes to the size of quota allocation.” Foreign access to the A-shares market is being controlled by the “Qualified Foreign Institutional Investor” quota limit, which is being relaxed in a gradual process.

It looks as if the opening-up and capital mobility processes will take a number of years. As a result, inclusion of the China A-shares in the MSCI Emerging Markets Index will likely follow a path of “gradual inclusion,” according to MSCI. That would reduce the possibility of the inclusion having a destabilizing effect. Full inclusion would drive China’s weight up to about 32% of the index, compared with the current 18% weight.

The two notable ongoing reviews are of the Korean and Taiwan markets for possible reclassification as developed markets. They are currently the second (14.7%) and fourth (10.7%) largest components of the MSCI Emerging Markets Index. A reclassification would have a major effect on that index. We note that the IMF already considers the South Korean economy to be a developed economy, but that classification does not consider the specific features of the equity market and the relevant regulations. MSCI indicates that neither country will be reclassified as long as a number of market accessibility deficiencies remain unaddressed. According to MSCI, many international institutional investors consider that the accessibility of these two markets is “not at Developed Market standards.”

International investors may profit from consulting the 2013 “MSCI Global Market Accessibility Review” also released last week and available for download on the MSCI website, www.msci.com. It provides a comparison of the 79 markets covered by MSCI with respect to openness to foreign ownership, free flow of capital, efficiency of the operational framework, and stability of the institutional framework.

The announced reclassifications have no impact on Cumberland Advisors’ investment strategies because the markets concerned are too small. There are no relevant ETFs that meet our minimum standards for liquidity and tradability. That is the situation for almost all frontier market ETFs, with one notable exception: Market Vectors Vietnam, VNM.

Frontier markets, having fewer links to international markets, have been less impacted by developments that have depressed emerging markets this year, such as concerns about when the US Fed will “taper” its bond purchases or about slower demand from China. Vietnam’s market has been helped by government plans to ease foreign ownership restrictions on stocks, overhaul the financial system, and restructure state enterprises. The economy looks set to continue to advance at a 5+% rate this year and in 2014. The Vietnam ETF VNM is up 12.6% year-to-date, in marked contrast to the 11.4% decline in the Emerging Markets EEM. Moreover, VNM gets a relatively high overall quality rating of B by our friends at Index Universe. Two notes of caution are the relatively high P/E of 16.5 and expense ratio of 0.76%.

BY Bill Witherell