Andrew Rymer, Schroders, reviews the evolution of the MSCI Emerging Markets Index and considers the emerging countries to watch for the future.
The transformation of emerging markets has been remarkable. The countries and companies that dominated 20 years ago have changed dramatically, influenced by the major geopolitical, economic and demographic changes that have taken place over this time.
Navigating these changes can be complex, but these developments underline the importance of taking a flexible, active approach and investing in the most attractive opportunities.
Emerging markets (EM) encapsulate a broad range of countries across different geographies. In simple terms, these are generally perceived to be a group of countries with strong potential economic growth and in turn stronger investment returns, albeit subject to greater political, legal, counterparty and operational risk. This is typically underpinned by an expanding middle class and rising wealth, as well as positive demographics and savings trends.
When it comes to investing, major index providers consider a range of factors when determining their definition of an EM. In addition to economic metrics such as GDP per capita, significant emphasis is also placed on market access.
This point is often underappreciated but it is important as it captures investors’ ability to put their money to work, as well as the ease of divesting in the future. The MSCI Emerging Markets is one of the most followed global EM indices.
The relevance of emerging markets continues to rise
As the chart below illustrates, the relevance of emerging markets shares to investors has increased significantly over the past 20 years. The share of EM companies as a percentage of the widely followed MSCI All Country World Index has increased from around 4% in 1998 to 11% today. It should of course be noted that this data immediately follows the Russian financial crisis in August 1998 and the Asian financial crisis in 1997, which had depressed EM asset values somewhat. Nonetheless, the share had previously peaked at just over 8% and in the most recent decade has been as high as almost 14%.
Historical trends are not indicative of future trends.
Breaking down the MSCI Emerging Markets Index
We have focused on the widely followed MSCI Emerging Markets Index. However, a good active manager will often look beyond the companies in this index to identify opportunities. Nonetheless, the index provides a good gauge of the opportunity set.
As at the end of September 2018 the index comprises 24 emerging markets countries. China is the dominant index country, with a weight - its share of the overall index - of almost 31%. Other Asian EM, South Korea and Taiwan are also significant with a weight of close to 15% and 12% respectively.
At the other end of the scale, Pakistan, which was reclassified from frontier markets in 2017, is the smallest index market with a weight of less than 0.1%. Frontier markets are typically less mature than EM on a range of metrics, including market size, liquidity (the ease of buying and selling stocks), foreign investor access and economic development. The precise definition varies by index provider. Egypt and the Czech Republic also have a small weight in the MSCI Emerging Markets Index, at 0.1% and 0.2% each.
Viewed from a sector perspective, financials and IT are clearly the dominant sectors with respective weights of 23.2% and 26.9%. By contrast, utilities, real estate and health care are the smallest index sectors with a share of 2.4%, 2.8% and 3.0% respectively.
Index country changes over time
Within EM in particular, a review of index country changes can be illustrative in tracking the evolution of EM over the past 20 years. The chart below provides a snapshot of index country weights at three points in time, the end of September 1998, 2008 and 2018.
Unsurprisingly, the most striking feature is the colossal rise of China from a weight of just 0.8% in 1998 to 31% today. The main driver of this transformation is the addition of Chinese companies to the index; China has performed broadly in line with the MSCI Emerging Markets Index over the past 20 years. This was initially through greater inclusion of Hong Kong-listed companies. Some US-listed Chinese companies were added to the MSCI Emerging Markets Index in 2014. But mainland Chinese companies, known as China-A Shares, were not officially considered for inclusion until 2014. This is one of the largest stock markets in the world and includes over three thousand companies.
The main barrier to inclusion was China’s cautious approach in permitting foreign investors to buy these stocks. Regulation rendered market accessibility unequal and also limited capital mobility. Over time, however, the authorities sought to liberalise and address investor concerns. This included the implementation of the China Stock Connect, which links the Hong Kong Stock Exchange with the mainland Shanghai Stock Exchange. In 2017, MSCI announced the partial inclusion of China-A Shares, which took place earlier this year. It is likely that more of these stocks are included over time.
South Korea has also seen its weight in the index rise markedly, from 5.5% in 1998 to 9.4% today. In part due to the rise of China, markets such as Mexico, Brazil and South Africa have seen their significance in the index moderate.
Meanwhile Russia, which had a weight of 0.9% in 1998, in the wake of the Russian financial crisis, saw its share rise to 8.4% in 2008, only to fall to 3.7% in 2018. These fluctuations reflect an initial recovery in the economy, crude oil price movements and later, the rise in geopolitical tensions, with the US and European Union implementing sanctions on the country.
Another notable change was in 2014 when the Middle Eastern markets of the UAE and Qatar were included in the MSCI Emerging Markets Index.
Other countries meanwhile have exited the index altogether. Venezuela, for example, was removed from the index in 2006 and Sri Lanka (which was later added to the MSCI Frontier Markets Index) was removed in 2001. The case of Venezuela highlights the importance of market access in determining EM status. Foreign exchange restrictions, introduced by the government, together with low levels of liquidity were significant obstacles for foreign investors, and were the main triggers for the country’s removal. Jordan, Argentina and Morocco were reclassified to the MSCI Frontier Markets in 2008, 2009 and 2013 respectively.
Conversely, Israel was reclassified to developed market status in 2010, moving into the MSCI World Index. Greece also entered the MSCI World, following an upgrade in 2001. It was subsequently taken back to emerging markets status in 2013, post the government-debt crisis.
Index sector changes over time
From a sector standpoint there have also been significant shifts, as indicated in the below chart.
Most notable is the major increase in the share of the IT sector, which accounted for around 5% of the index in 1998 but is now close to 27%. The emergence and expansion of the internet and subsequently smartphones were major drivers of this shift. It also correlates with the rise in the significance of Asian markets. Over this period, Asia became dominant as a manufacturing hub for technology companies. Meanwhile there was a marked rise home-grown internet and gaming companies, particularly in China but also in South Korea.
The sectors which have seen a clear reduction in their index weight are telecommunications services and materials, down from 15.8% and 16.4% respectively in 1998 to 4.5% and 7.9% today. In 1998 telecoms offered investors exposure to domestic growth in many EM, but today there are better alternatives with more attractive fundamentals.
Financials meanwhile has maintained a steady weight; it accounted for 21.0% in 1998 and is now 23.2%. Real estate was added as a sector for the first time in 2016. These companies were previously categorised under the financials sector.
The data for 2008 also shows a pick up in the energy sector. Together with materials, these resource sectors accounted for almost 32% of the index. This was up from below 23% in 1998 and just 16.1% today.
Top 10 stocks through time
Reviewing the top 10 stocks at the same snapshots in time shows the regional shift that was evident at a country level, with seven out of the top 10 in 1998 all based in Latin America. By contrast, the top 10 stocks today are all effectively in Asia. Naspers, a South African listed stock has a material share holding in Tencent, which accounts for the majority of the value in the stock.
There is also a clear shift in terms of sector representation, in line with the trend discussed above. In 1998, telecoms and utilities stocks had a significant weight. Today there is only one telecoms stock in the top 10.
Interestingly, the top 10 stocks now represent a significantly higher proportion of the index. In 1998 they accounted for 16.7% of the index. This had increased to 21.3% in 2008 and today sits at 24%. The level of concentration has therefore increased. This is despite the total number of stocks actually having increased, rising from 958 in 1998 to 1151 today.
A major driver of revision to EM indices is not typically a dramatic change in an economic indicator such as GDP per capita. It is the removal of restrictions which limit market access. Over the past 20 years, China has been the most significant example of such change, as highlighted earlier.
Among the scheduled changes to the index are the inclusion of Saudi Arabia and the re-entry of Argentina in May 2019. Saudi Arabia is not currently in MSCI’s emerging or frontier indices. But since 2015, when the country permitted the direct foreign ownership of stocks, Saudi Arabia has undertaken reforms aimed at improving accessibility. Argentina will be reclassified to emerging markets, having been moved to the MSCI Frontier Markets in 2009 following the implementation of capital controls. These have now been removed.
Meanwhile, Kuwait has been added to the list for review, with a decision expected in May 2019 and inclusion unlikely before 2020. Looking further ahead, there is potential for China’s share of the index to rise further. The liberalisation of the market over the past decade has led to improved access for investors. There are not only further A shares which could be consolidated, in addition to a range of other Chinese companies, such as non-government owned companies which are incorporated outside of China, listed in Hong Kong; often referred to as P-Chips.
There is the prospect that other markets from the MSCI Frontier Index could be upgraded. Vietnam is an example, although a number of impediments to such a move remain. These include limits on foreign ownership of stocks.
Equally, it may be that in time certain markets are upgraded to developed markets status. Index provider FTSE already classifies South Korea as a developed market for example. This is because is puts greater weight on South Korea’s economic strength. MSCI, by contrast, views technical issues, such as restrictions on currency trading, as hurdles to developed market status. FTSE has recently upgraded Poland to developed market status.
Structural changes in the way people communicate, access media and shop have posed questions over sector categorisation. E-commerce companies for example are currently classified under IT. In light of this, the telecommunication services sector will be renamed as communications services from 3 December. As part of this change, media companies will be re-categorised from consumer discretionary to communication services while internet service companies will move from IT to communication services. Lastly, e-commerce companies switch from IT to consumer discretionary.
The growth story remains important for investors
There are a number of different factors behind changes in the MSCI Emerging Markets Index. We have highlighted some of these but concede that much time could be spent looking at more detailed changes. What is clear, however, is the dynamism of EM equities, and the structural growth story which these stocks offer. EM equities can have a more important role than ever in helping investors meet their goals.
These changes also draw attention to the fact that active management in emerging markets is vital, as we have highlighted previously. The index is unlikely to remain static and is an element to consider when investing in EM. Those investors with the capability to take off-index or off-benchmark positions can take advantage of these developments. Furthermore, EM equities remain inefficient, providing an opportunity for active investors to exploit. The higher concentration of the index in the top ten stocks also means that simple passive investment does not provide sufficient weight to many attractive investment opportunities.
The value of investments and the income from them may go down as well as up and investors may not get back the amounts originally invested.
This article has first been published on schroders.com.