Emerging markets indices: is fundamental change coming?

The 24 countries that make up the MSCI Emerging Markets index are vastly different not only in terms of macro-economics but also risk

MSCI said in June it had added Saudi Arabia to its watchlist for possible addition to its emerging market measure of stocks. Saudi Arabia Simon Dawson / Bloomberg

The inclusion of the UAE, Qatar and – expected soon – Saudi Arabia in the FTSE Russell and MSCI Emerging Market indices is expected to bring many benefits.

Institutional funds that track the index will include GCC stocks in their portfolios, adding liquidity, new investors and a truly international investor base. These new investors bring higher standards to the region, greater transparency and demand for world-class disclosure levels.

Regional companies will benefit from greater international interest, while regional investors will benefit from rising standards, and the GCC would gain the recognition it deserves for its strongest companies. But now a new mood is being seen in the investment community. Informed market participants are questioning the logic and make-up of emerging market indices.

The Financial Times recently called the MSCI Emerging Markets Index “a triumph of marketing over judgement”. The 24 countries that make up the index hide vast discrepancies: large countries (Brazil, China, Russia) are bundled with small (Chile, Hungary, Qatar). Commodity exporters (UAE, Malaysia) sit alongside commodity importers (South Korea, Taiwan). And it is not only macroeconomics that are being questioned. The risk factors in these countries are widely different.

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Saudi Arabia added to watchlist for emerging market status by MSCI

Saudis expect entry to MSCI index by 2019

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For Mexico, the greatest risk is its future relations with the United States. For South Korea, its neighbour to the north provides the greatest risk. How are these correlated? And should they be? These questions must also be set against the current debate over the merits of active versus passive investment strategies. After years of rebalancing away from active managers towards index benchmarks and tracker funds, in today’s low-yield world, the attractions of active fund managers are returning to favour. These and other factors are informing the debate around the future of emerging market indices, to the extent that voices in the investment world are seriously questioning whether they should even exist.

The world is so different from the 1980’s when emerging market indices first appeared, that they no longer reflect reality, nor do they serve the interests of investors. So where does this leave the GCC? And if the days of the emerging market index are numbered, what should companies do to protect themselves from any outflow of capital?

Fortunately, this would not be a sudden change. There is $1.6 trillion following the MSCI index, and that will take time to unwind. Furthermore, the reasons for the creation of the indices remain true: fast growing countries with young populations, well-managed capital markets and stable systems of government are a good bet for sustainable future growth. But change will come, and far-sighted GCC companies can take steps to position themselves for a new era. Benchmark indices will not disappear – but they are expected to change.

So what will the new measures and standards for inclusion be? In other words, what is the investor of the future going to look for? Many factors will drive the future of investing, including technology (artificial intelligence, the internet of things, fintech); global trade (commodities cycle, China’s return to growth, slowing developed markets); and climate change. These global themes are likely to be more of a driving force for investment allocation than emerging or frontier market status.

One term that will be heard more and more is Environmental, Social and Governance (ESG) benchmarks. This is the classification of companies judged by their environmental activities, corporate governance, social impact and other factors that measure a company’s record in these “softer” areas, rather than purely its financial performance. GCC companies can be sure that ESG will be a growing factor in investor decisions, and they can take immediate steps to focus on these factors in their operations. Whatever the future holds, one trend is rapidly becoming apparent: the term Emerging Market is no longer adequate to determine allocation strategies for sophisticated investors. Regional firms would be wise not to rely on it.

Oliver Schutzmann is founder and chief executive of Iridium Investor Relations, an advisory and technology firm