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What is an emerging market?

Patricia Oey  |  09 Jun 2016Text size  Decrease  Increase  |  

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In April this year, the World Bank released its 2016 edition of World Development Indicators, and for the first time, it stopped classifying countries as "developing" and "developed".

According to the organisation, the distinction was no longer relevant, as it aims to use a set of sustainable development goals that can be applied to all countries.

The investment world, for the most part, continues to view developed and developing (or emerging) markets as two separate allocations within a diversified portfolio.

And the question "what is an emerging market" comes up when MSCI makes its annual announcement regarding market (or country) changes to its developed-markets and emerging-markets indexes.

This year, MSCI will make its announcement on 14 June. If a change is to be made, it is typically implemented within a year.

MSCI works with the investment community on these decisions and conducts a consultation period of at least one year with industry participants.

Changes under consideration for the 2016 announcement include Pakistan (from frontier market to emerging market), China A-Shares (from stand-alone to emerging), and Peru (from emerging to frontier).

There are no emerging-market countries under review for potential reclassification to developed-market status.

When MSCI decides to move a country in or out of the MSCI Emerging Markets Index, funds that track this index have to implement these changes when the index does. Active managers, on the other hand, can make changes at their discretion.

The addition of countries with small capital markets has little impact on both passively managed and actively managed funds.

For example, if Pakistan were to be added to the MSCI Emerging Markets Index, it will account for less than 1 per cent.

But the addition or deletion of a large market can have a significant impact on the portfolios of both actively managed and passively managed funds.

China A-Shares is a large market. It includes companies listed in China either on the Shanghai or Shenzhen stock exchanges. Historically, foreigners had very limited access to these shares.

During the past few years, Chinese regulators have been carefully opening up its markets, in part to draw global investors into its capital markets.

At current prices, the inclusion of China A-Shares would account for about 20 per cent of the MSCI Emerging Markets Index (for a total China allocation of 40 per cent, including the existing overseas China listings).

If China A-Shares were to be added, MSCI would cap their weighting to 1 per cent within the MSCI Emerging Markets Index and scale up this allocation over time.

The inclusion of China A-Shares was under consideration last year, and leading up to the June 2015 announcement, the CSI 300 Index (the China A-Share benchmark) returned more than 130 per cent.

Most of this rally was attributed to local Chinese investors who piled into the market to try to get ahead of anticipated large foreign fund flows should MSCI decide to include China A-Shares into its MSCI Emerging Markets Index.

This year, local Chinese markets are in a completely different mood. Year to date, the CSI 300 is down about 15 per cent, and from the peak one year ago, the market is down 40 per cent.

That said, the CSI 300 is still about 50 per cent higher than it was two years ago. It looks like Chinese investors have low expectations that MSCI will announce the inclusion of China A-Shares next week.

In fact, MSCI has said its announcement regarding the inclusion of China A-Shares into its MSCI Emerging Markets Index could occur outside of its annual Market Classification Review cycle.

This is because MSCI is waiting for more clarity from the Chinese government on rules regarding foreign investor accessibility and capital mobility.

The index provider said when China brings its rules regarding these issues in line with MSCI's criteria, it will announce the timeline for China A-Share inclusion into its emerging-markets index.

Even if MSCI does not decide to include China A-Shares into the MSCI Emerging Markets Index now, it will likely do so in the not-too-distant future.

MSCI said the weighting of China A-Shares will be capped at a low allocation, but that this will gradually rise.

Investors in emerging-markets index funds should consider if they want to hold a fund whose already large China allocation (at around 25 per cent) is likely to grow in the coming years.

More from Morningstar

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• A case for investing in infrastructure securities

 

Patricia Oey is a US-based senior analyst covering international-equity strategies on Morningstar's manager research team.

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