The impact of inclusion in global capital markets indices

The period of easily raising funds from abroad seems to be coming to an end for emerging markets around the world. Amid rising interest rates in the US and increased competition for capital flows, portfolio managers are becoming more selective with where they invest. One way for developing nations to ensure that their financial markets can continue to attract foreign funds and remain sustainably liquid is by being included in well-regarded benchmark indices. In addition to drawing in fund managers, inclusion on such indices requires meeting specific standards that show that the participating countries apply certain regulations and best practices.

Recent Upgrades

In June 2018 stock market index provider MSCI granted Argentina and Saudi Arabia emerging market status – upgrading Argentina from a frontier market and including Saudi Arabia in its indices for the first time – and both are set to be included in the MSCI Emerging Markets Index beginning in mid-2019. In June 2017 MSCI had chosen to maintain Argentina’s frontier status, noting that while the country had met most of the criteria for an upgrade, positive changes regarding market accessibility needed to remain in place to be deemed irreversible. Even though challenges persisted into the following year, demonstrated by a drastic sell-off of the peso between late April and June 2018, MSCI felt confident that Argentina would not return to its practices of market interference.

A Closer Look

FTSE Russell and MSCI use specific criteria to determine a country’s classification as frontier, emerging or developed, including size and liquidity measurements and market accessibility factors. Frontier nations display traits that translate into riskier bets for global investors. However, these risks are generally related to equity market practices and do not directly translate to the stability of an entire economy. For example, the MSCI Frontier Markets Index lists many countries that boast investment-grade credit ratings, meaning their economies are strong enough that evaluators do not deem their sovereign debt risky. Indeed, some frontier markets, such as Kuwait, Estonia and Lithuania, have “A” credit ratings – better than countries like Portugal, Spain and Italy whose exchanges MSCI’s classifies as developed. Other countries are not included in either of MSCI’s emerging or frontier listings, but are monitored with standalone indices that use the same methods of evaluating size and liquidity.

Reform

The recent MSCI upgrades are the direct results of public reforms to open their financial markets to global investors and specialised products. Argentina’s reclassification, for example, followed the repayment of the sovereign debt on which it defaulted in 2001. Among other measures, the administration has removed foreign exchange restrictions and capital controls, eliminated cash reserves and monthly repatriation limits in the equity market, and abolished lock-up periods for investments. The stock market also aligned its settlement cycle with others around the world, moving from a T+3 to a T+2 system, such that trades are now settled in two days, rather than three.

Saudi Arabia’s own reform is part of the Vision 2030 economic plan to increase investment and reduce its reliance on oil. In April 2018 the country also switched to a T+2 settlement cycle from a sameday settlement system. Listed companies are also aligning their accounting practices with International Financial Reporting Standards, enabling their financial statements to be directly compared to those in countries with the same system, and restrictions have been eased on the entry of foreign investors into the kingdom’s capital markets.

Matter Of Prestige

Beyond technical frameworks and revised regulations, a classification upgrade can have a ripple effect across the entire economy and improve a country’s business reputation. “It has importance as a public relations and marketing concept,” Robert Abad, founder of US emerging market advisory firm EM+BRACE, told OBG. “Previously, emerging economies were simply synonymous with ‘less developed’.” Speaking to Argentina’s history, he added, “One hundred years ago the country was a trading giant and the eighth-richest country in the world. Being labelled as a frontier market placed it in the same bucket as apparently third-tier countries. The emerging market classification raises Argentina’s status.”

This aligns with the local view of Federico Sidi, the Argentine equity portfolio manager at Compass Group, a Latin American advisory firm. “The government is pushing for this type of recognition as a kind of seal of quality or trademark,” Sidi told OBG. “It is not just financial markets – Argentina wants to join the OECD and use the hosting of the 2018 G20 summit to show the world how the country has bettered itself.” While agreeing that Argentina’s global visibility and reputation will likely improve, Matías Lara Mateos, investor relations officer at Bolsas y Mercados Argentinos (BYMA), the local stock exchange, added that the enhanced perception of the country could also reduce national financial risk.

Numbers Game

The biggest material effect of an index upgrade is the amount of money that a country’s capital markets will be able to attract. Benchmarks hold considerable power in the global investment arena: MSCI notes that 99 out of the top-100 global investment managers were among its clients as of December 2017, and the firm estimates that its indices are the primary benchmark for more than 85% of all internationally focused fund assets.

Before Argentina’s upgrade, JP Morgan estimated that $463bn worth of funds were passively tracking MSCI’s Emerging Markets Index. In April 2018 MSCI stated that Argentina would likely represent 0.6% of the index should it be reclassified, translating into approximately $2.78bn of passive inflows. Meanwhile, active emerging market investors manage around $1.2trn Should these investors retain their neutral positions, new active inflows to Argentina are expected to approach $2.7bn, matching JP Morgan’s forecast that its stock market will experience around $5.5bn of inflows after reclassification. With daily trading volumes on the BYMA in the first quarter of 2018 averaging $50m, more investor activity would have a huge impact on liquidity.

Wider Scope

Jan Dehn, head of research at Ashmore, noted that emerging markets account for 60% of global GDP, but just 20% of global finance. In his view, the problem is a lack of representation of most developing countries in equity and debt markets alike, and he suggested that multilateral organisations such as the IMF or the World Bank could provide more inclusive indices. Most developing countries’ governments rely far more on domestic than international debt markets for finance, and Dehn has argued that the provision of local bond markets could be considered a “public good”, as doing so would improve government access to funding as well as reduce certain financial risks and inefficiencies. “As an institutional investor, it is in your interest to have access to as broad a spectrum of the market as possible,” he told OBG. “With more comprehensive indices, investors around the world would benefit from more diversification and increased investment opportunities.”

In Perspective

As nations look to modernise their markets, they must remember that an index upgrade is a signal of efforts moving in the right direction, not the driver of change itself. “MSCI including Argentina in its Emerging Markets Index is just one step in the development of the local market,” Lara Mateos told OBG. “There is a lot of work to do beyond MSCI’s assessment, with education a major priority.” While a reclassification can focus attention on capital markets, the regulations implemented to secure the change are of much greater fundamental importance. Still, if a country’s upgrade on a popular index can play even a small role in increasing awareness of its financial markets, it is worth promoting.

To that end, and amid the tighter global monetary conditions, many emerging markets are set to continue striving for increased recognition and global exposure from index providers.

Transition Troubles

What these inflows mean for share prices is hard to predict. Where necessary, MSCI and FTSE Russell stagger the inclusion of individual countries by gradually increasing their weight in indices. However, while inflows from passive accounts are concentrated around the inclusion date, active managers tend to anticipate the change before it is implemented. Often this means that any market rally comes before the official inclusion. For instance, Qatar’s index boasted implied returns of approximately 38% in the 11 months between MSCI’s reclassification announcement in June 2013 and the country’s official inclusion, compared to 12% for the MSCI Emerging Markets Index as whole.

This is not always sustainable. Pakistan’s stock market hit a record high after MSCI upgraded it from frontier to emerging in June 2017; however, by the end of that year the KSE-100, which measures the performance of the exchange, posted negative returns in excess of 15% – or 20% in dollar terms – as inflows did not arrive as expected. With a weight of just 0.1% of the index, Pakistan is proving to be less attractive to large fund managers than other markets. “Pakistan is at risk of being left out of the financing race, as I do not believe that core global emerging market managers are looking at it closely,” Edward Evans, equities portfolio manager at Ashmore, told OBG.

Beyond the Benchmark

Although index upgrades convey many benefits, indices do not tell the whole story about a capital market, and index exclusion does not necessarily mean that a country or an exchange is unsophisticated. Ashmore’s Evans said he does not place much importance on index inclusion when he looks at where to invest. “There is a wider, very attractive universe out there beyond the indices,” Evans told OBG. “Exclusively following an index provider means you are exposed to a very narrow representation of all emerging markets.”