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Aon Retirement and Investment Blog

MSCI EM Index Changes

MSCI EM Index Changes
Index providers such as MSCI and FTSE periodically review the structure and constituents of their indices, with stocks and countries considered for inclusion or removal. As part of this process, changes to the MSCI Emerging Markets Index occurred recently, and more changes are forthcoming. By far the most documented of these changes is the recent approval for partial inclusion of Chinese A-Shares into mainstream indices. For more background on Chinese A-Shares, please refer to recent Aon publication, ‘MSCI’s Announcement to Add China A-Shares to its Emerging Markets Index - Looking Beyond the Tiny Percentage’.
Despite this announcement making most of the headlines, this note touches on two different and less covered announcements of index composition. Firstly, Pakistan, which was upgraded from frontier to emerging market status in May 2017 and secondly Argentina, whose aspiration to be promoted back to the MSCI Emerging Markets Index was rejected in June 2017. Whilst these countries have interesting stories, and symbolize some of the core reasons for investing in emerging markets - reform, secular growth in consumer and financial services and provision of diversification, the outcome of these decisions would likely provide little to no benefit to passive or index- aware EM investors, with only a de-minimis exposure in the overall benchmark being up for consideration, and highlights an ongoing draw-back to these types of approach within emerging markets investing.
Pakistan entered the MSCI Emerging Markets Index in May 2017. In the past, Pakistan’s per capita income has been superior to India and China, which have both since accelerated past and beyond their neighbor. The country was removed from the MSCI Emerging Markets Index in December 2008 following deterioration in investment conditions in the midst of the financial crisis - stock price control mechanisms and effective floors to share prices were put in place. Since then these controls have been lifted and the market has grown in size and liquidity.
Today, Pakistan benefits from favorable population demographics; a young population of close to 200 million with improving literacy and education enrollments, and a rising middle class that is growing from a low base. Pakistan may benefit from cheaper labor costs relative to the rising prosperity of its neighbors; and from multi-billions of foreign direct investment in to roads, railways, ports and power plants, as part of the China-Pakistan economic corridor, which forms part of China’s larger ‘One Belt, One Road’ project, rekindling the old Silk trade routes. Lastly, Pakistan comes with the current benefit of low correlation to mainstream indices, at around 0.2 to the MSCI Emerging Markets Index, versus 0.8 for a large index constituent such as Korea.
Of a local index containing over a hundred companies, only six of these will be included in the broad MSCI Emerging Markets Index, and Pakistan will have a weight of less than 0.5% in index tracking solutions.

In the early 20th century Argentina was one of the largest economic powers in the world, but economic progress since stalled and political instability in the country has been high. In more recent times Argentina was downgraded from the MSCI Emerging Markets Index in 2009 because of restrictions on capital flows under the Kirchner presidential regime. Fast-forward eight years and under centre right reformist President Mauricio Macri, capital controls have been lifted, the currency allowed to float, a decade long default law-suit has been settled, and market friendly reforms around energy tariffs have been implemented. Political change, reform and expectation of promotion into the MSCI Emerging Markets Index pushed the MSCI Argentina Index up around 40% in USD over the year to date. However, MSCI deemed it too soon for promotion, so Argentina will wait at least another year.

Whilst reform presents much of an investment thesis for Argentina, market penetration rates in areas such as Financial Services remain low, but may be an area of structural growth as financial conditions improve and inflation is tamed. Despite a number of IPO’s being scheduled for 2017, and existing relatively large and liquid companies headquartered in Buenos Aires such as oil refiner YPF, internet retailer Mercado Libre, and McDonald's Franchiser Arcos Dorados, Argentina’s weight in the new MSCI Emerging Markets Index would have entered at less than 1% of the index. Argentina also has a lower correlation to mainstream indices than larger index constituents.
Whilst these two countries, not least Pakistan, have more than their fair share of ongoing risks and concerns, they do offer some potentially favorable investment characteristics. Alongside many of the smaller emerging market countries, these countries present potential opportunities for select investments at certain times.

Argentina and Pakistan are topical examples of how interesting stories and secular trends in emerging markets can be in tail of the benchmark, or off it entirely. It is these markets that can be the most ‘emerging’ and come with the added benefit of greater diversification benefits relative to the globally integrated mega-caps at the top of the index. Even when such markets are included in the index, the weights are likely to be small that passive and index-aware investors will likely not have a significant exposure.

Where governance structures and time horizons permit, this is why we encourage clients to consider our most unconstrained emerging markets managers, where more material exposures to smaller index components and off benchmark exposure can be made when managers deem appropriate

James Jackson is a Senior Consultant and equity specialist in Aon Hewitt’s Global Investment Manager research team in London.

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