Changes in emerging market indices

Emerging market investing is being shaken up this year with changes to the way China, Saudi Arabia and South Korea are represented in indices

Daniel Sotiroff 29 April, 2019 | 5:00PM

Note: This article is part of Morningstar Canada's Emerging Markets Week Special Report

China's ascendance in emerging markets stock indices over the past decade is indisputable. In March 2009, the country represented 12% of the MSCI Emerging Markets Index. Fast forward 10 years, and that had swelled to just under 33%. The numbers are similar for emerging markets benchmarks from other providers like FTSE Russell and S&P Dow Jones Indices. Strong returns from the Chinese stock market relative to other developing markets drove most of that growth.

More recently, emerging markets indices have expanded their reach to include stocks from the China A-share market, which has further increased China's share of the emerging markets pie. Prior to May 2018, China A-shares, or renminbi-denominated shares that traded locally on the Shenzhen and Shanghai exchanges, were excluded from the MSCI Emerging Markets Index and other emerging markets benchmarks. Index providers shied away from including them because they were difficult to trade. The Chinese government restricted access to a select set of institutional investors and imposed quotas that further constrained the investability of these stocks.

A-share access expands

But access to the China A-share market has improved significantly over the past several years. Chinese regulators have slowly upped quotas available to institutions. The advent of the Stock Connect programmes, which provide investors with the ability to trade China A-shares through Hong Kong brokers, was another major milestone.

Better access to China A-shares has led index providers to recognise their role in the emerging markets universe. The flagship MSCI Emerging Markets Index added 222 large-cap China A-shares to its roster of constituents in May 2018 and will add more in May and November 2019. Consequently, funds that track the MSCI Emerging Markets or MSCI ACWI indices will have greater exposure to the China A-share market.

MSCI expects that China A-shares will occupy about 3.3% of the MSCI Emerging Markets Index after the November 2019 rebalance.

Other index providers have also started to recognise the role of China A-shares in the emerging-markets universe. FTSE Russell and S&P Dow Jones Indices have announced plans to add these stocks to their emerging markets benchmarks starting in 2019. China A-shares may occupy 5.5% of the FTSE Emerging Index by March 2020 and 5.5% of the S&P Emerging Broad Market Index by September 2019.

Saudi Arabia Joins the Club

Saudi Arabian stocks will find their way into the MSCI Emerging Markets Index and MSCI All Country World Index. MSCI plans to add Saudi stocks in two phases at the May 2019 and August 2019 index reviews. Improved foreign investor access to the Saudi market drove this decision.

From a composition perspective, MSCI expects these stocks to account for roughly 2.6% of the Emerging Markets Index after the August rebalance. The Saudi Arabian market is relatively small and concentrated. It has only 69 member stocks and is dominated by those in the materials and financials sectors. While this market doesn't offer great diversification on its own, it does increase the breadth of the index while providing some counterbalance to markets with a larger representation, like China and South Korea.

Currency exposure may also provide a modest benefit. Saudi Arabia's currency, the riyal, is pegged to the US dollar. So including these stocks does not introduce additional currency risk for dollar investors.

Other changes to indices globally including the decommissioning of the Russell Global Index. The outgoing Russell benchmark classified South Korea as an emerging market, while the incoming FTSE index assigns it developed markets status.

Let's not forget the magnitude of these changes at the global level. After these next stages of inclusion, MSCI expects that China A-shares will make up about 0.4% of the MSCI ACWI Index, and Saudi Arabia's share of the global investable pie should be slightly less than that figure. Overall, these two additions represent less than 1% of total global market capitalisation. While small in number, these changes are more meaningful in that smaller markets are being accepted into the global community.

Keep in mind that changes like these are emblematic of developing nations. Emerging markets, almost by definition, lack the mature legal systems, infrastructure, and government stability that developed countries like the United States, Europe, and Japan enjoy. Consequently, the composition of emerging markets indices will continue to change, sometimes rapidly, to reflect the evolution of their economies.

About Author

Daniel Sotiroff

Daniel Sotiroff  Daniel Sotiroff is a manager research analyst for Morningstar.