MSCI’s ‘constant’ reclassifications can take 12% toll on country indexes


Franklin Templeton emerging markets fund manager Carlos Hardenberg says he strongly disagrees with the “constant reclassification” of markets by index providers as new research reveals the more than 12 per cent hit countries take from MSCI upgrades and downgrades.

Pakistan is the most recent country to shift from frontier to developed market status moving to the new index in June.

Hardenberg notes Argentina is rumoured to be following in Pakistan’s footsteps, but warns they may not be happy to do so.

“Pakistan was about 8 per cent of the frontier market index and they were upgraded to 0.12 per cent of the emerging market index. I’m not so sure they’re that happy about that. The stock market first went up and then it collapsed.”

He adds: “I really disagree with it so much, this constant upgrading and downgrading of markets.”

The average country reclassified to a more-benchmarked index gains 23.2 per cent between the announcement and the reshuffle, but loses 12.4 per cent in the year that follows its inclusion in the new index, research out of NYU’s Stern School of Business, Chapman University and Acadian Asset Management shows.

The reverse is true of countries moving to less-benchmarked indexes with the country index taxing a 12.5 per cent hit in the lead up to the effective date, but then delivering 23.3 per cent returns the in the year that follows.

The research paper, Investing in the presence of massive inflows: the case of MSCI country reclassifications, notes $10trn is benchmarked against MSCI indices and thousands of investors have to decide how to act when a country is upgraded or downgraded.

Emerging markets are the most benchmarked index with 45 per cent, compared to 22 per cent for frontier markets and 6 per cent in the ACWI. However, many more dollars are benchmarked to developed than emerging markets.

In April, Jupiter announced the launch of the Emerging & Frontier Income Trust, which fund manager Charlie Sunnucks says developed in part because “so many countries out there are fundamentally misclassified”.

Currently MSCI is consulting on the potential reclassification of Saudi Arabia from a standalone index to emerging markets, while it is also mulling upgrades for Nigeria and Argentina from frontier to emerging markets.

MSCI assesses the size and liquidity of capital markets as well as market accessibility, such as openness to foreign ownership, when considering market classifications. In the case of developed markets, gross national income per capita must be 25 per cent higher than the World Bank average.

Sunnucks notes that Habib Bank enjoyed a good year running up to Pakistan’s inclusion upgrade to emerging markets, but has disappointed since, although he notes it’s early days.

“That’s one of the companies that proves it’s better to travel than arrive perhaps,” Sunnucks says. “Since the inclusion date the stocks actually come off quite a bit. You do get close to the date and I do think a lot of short-term money piles in there and not necessarily into the stocks that are propped up by a fundamental valuation.”

Frontier markets Peru and Georgia should arguably be in the emerging index, while “everyone anticipates every year” that Korea or Taiwan will be bumped up to developed market indices, Sunnucks says.

“Being able to access both emerging and frontier markets within a mandate gives us the scope to take advantage of these changes as countries get shifted between the two.”

However, he points out the fund is unconstrained and if countries were upgraded to developed market indices the managers would assess holdings based on their emerging market exposure.

“We have a Taiwanese bike company, Merida, and a lot of their production is in China. They sell to other emerging markets from Latam to Asia, so for us that’s an emerging market stock.”

The research paper on MSCI reclassifications notes that even as a country is upgraded from frontier to emerging market there will be some stocks that do not satisfy the requirements of the new index and so demand from benchmarked investors will fall.

It recommends fund managers benchmarked to frontier should wait to sell on the effective date that a country is upgraded to ride the net buying pressure before the effective date, although if emerging market investors bought at the effective date they would do so as stocks peaked.

It says those fund managers could buy at the announcement date and hold through the run-up and reversion or buy well after the effective date when the cycle has played out, although it notes both strategies involve tracking error.