Are emerging markets destined to be the developed markets of the future?

MSCI’s annual review will promote some China A-share stocks to the MSCI Emerging Market Index, but at a smaller weight than investors expected, while Argentina missed out. The index has evolved over time, but not always in the way you might expect.

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Emerging markets figure

Investors in emerging markets often assume that they are investing in the developed markets of the future, with it seeming natural that emerging market countries with their young populations and improving economies will grow faster over time.  

MSCI run the best known emerging market classification index, which was launched in 1988. For countries to gain membership, their stock markets have to conform to particular rules on liquidity, number of stocks available to invest in, free float and currency convertibility, all of which are designed to make access easier and more transparent for investors. 

MSCI’s annual decision on whether to promote countries from emerging market status to developed, or to demote them from emerging to frontier market status wields a lot of power as index tracking products are required to change their allocations and billions of dollars of assets may require redeployment. For example in June 2013, MSCI announced that Qatar and UAE would be promoted to emerging status a year later in June 2014. Gulf investors had been waiting for this moment for many years, and over the following 12 months the indices advanced in USD terms by 38.2% and 73.6% respectively.   

Looking back in time, when the MSCI Emerging Market Index was launched in 1988, it included just 10 countries of which Malaysia and Brazil accounted for more than half the market cap. Those countries were Argentina, Brazil, Chile, Greece, Jordan, Malaysia, Mexico, Philippines, Portugal and Thailand. It’s fair to say that their track records have been mixed, and looking at the evidence there has been no natural progression to developed market status, though in many cases investors have made large financial gains. 

From the starting 10, Argentina and Jordan were later demoted to frontier market status, while Portugal and Greece were accorded developed market status, only for Greece to be demoted back to emerging in 2013. 

In fact looking at the MSCI Emerging Market Index over the past thirty years, there have been more demotions to frontier market, than promotions to developed. Morocco, Pakistan and Sri Lanka joined Argentina and Jordan in the Frontier Market Index, while Venezuela was dropped entirely.

On the other side of the coin, Israel has joined Portugal in being elevated to the Developed Market Index. 

What happened in the latest MSCI index review?
MSCI announced that they would include 222 China A-Share stocks in the Emerging Marked Index in May and August next year, an increase in China’s weight of 0.73%. These stocks can be accessed through the ‘Stock Connect’, and therefore have fewer capital control restrictions that mainland China stocks suffer from.  

China already makes up 27.9% of the MSCI Emerging Market index, but the existing investible stocks are listed largely in Hong Kong and to some extent in the US where the large technology companies such as Baidu and Alibaba have listings.

MSCI also announced that they would not promote Argentina to emerging status, even though it now meets the criteria for inclusion, as ‘the irreversibility of the relatively recent changes still remains to be assessed’. Argentina’s local MERVAL index fell on the announcement, but has more than doubled since President Mauricio Macri took office 18 months ago. 

China is an increasingly large weight in the index, how can I diversify my Emerging Market exposure?
ETF investors have a multitude of different products which they can invest in, with most individual countries available under the iShares brand and other providers offer a number of regional ETFs as well as small cap and income focused products.  

An interesting antidote to those investors that like emerging markets, but are concerned about Chinese corporate governance is the iShares MSCI EM SRI UCITS ETF (SUSM) which charges 0.35% and has just a 3.5% allocation to China. MSCI have been running the index strategy for six years, with nearly 3% a year annual outperformance of the conventional index.

For more emerging market ETF ideas read our article: Six of the Best emerging markets ETFs.

All the ETFs described can be bought on IG’s share dealing platform, where commissions start at just £5 and there are no custody or platform fees.

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