Game changer for emerging markets
Fund investors face new risk after strong rally — this time from index shuffle
By Sam Mamudi, MarketWatch
Last update: 5:39 p.m. EDT April 3, 2009
NEW YORK (MarketWatch) — Emerging markets are on fire, posting double-digit gains in March and attracting huge amounts of new investment to these volatile regions as they lead the global rally in stocks this spring.
But investors in emerging-markets mutual funds and exchange-traded funds may soon face a shakeup just as they’re recovering from one of the roughest periods ever: major changes to the benchmark index that is gospel for many fund managers and ETFs.
MSCI Barra (MXB) is considering as many as five country changes to its Emerging Markets Index, the standard measure for many funds. Though some fund managers downplay the significance, the changes could make emerging markets funds more volatile and worsen their performance. They could also force managers to sell holdings or at least alter investment strategies.
“Unlike other regional funds, such as a European fund, such changes are an ongoing issue for emerging markets funds,” said William Rocco, fund analyst at investment researcher Morningstar Inc.
The prospective changes in June would come just as emerging markets funds are regaining their swagger. Emerging markets stock funds attracted $2.3 billion of new money in the week ending March 25 –– their best week since mid-December. Another $1.2 billion was added in the week ended April 1, according to researcher EPFR Global.
Buyers clearly were drawn to the group’s powerful gains: The iShares MSCI Emerging Markets Index ETF (EEM) was up 15.3% in March; sibling iShares MSCI BRIC Index (BKF) , which covers Brazil, Russia, India and China, gained 14.2% in the same period.
MSCI announced in June that South Korea and Israel may be upgraded to developed markets status, which would include them in the key MSCI EAFE Index, which covers Europe, Australasia and the Far East, and a representative ETF — MSCI EAFE Index Fund (EFA) .
MSCI also said that Kuwait, Qatar and the United Arab Emirates may join the Emerging Markets Index.
Promoting South Korea would remove a country that is about 12% of the MSCI emerging markets benchmark. Israel, meanwhile, represents about 4% of the Index. Any upgrade would be the first since Greece in 2001 and Portugal in 1997.
“Korea would definitely be a big change,” said Remy Briand, global head of index research at MSCI.
But Korea’s exit would likely hurt performance of the Emerging Markets Index, at least in the short term. The iShares MSCI South Korea Index ETF (EWY) was up 26.1% in March, giving the broad benchmark a boost.
The move could also make the Emerging Markets Index more volatile.
“Upgrading Korea would make the emerging markets a more risky investment because it’s a stable market,” said Wyatt Crumpler, co-manager of American Beacon Emerging Markets Fund (AAMRX) .
Impact to index funds
One class of funds that will be directly hit if MSCI does make changes will be index-tracking emerging markets funds, which have more than $30 billion in assets.
A typical view of emerging markets investing is that investors benefit from active management because superior stocks can be hard to find in little-known, illiquid markets. But, said Gregg Wolper, senior fund analyst at Morningstar, because the category’s performance in good times can be stellar, some investors are comfortable paying lower fees for index funds and accepting the broad returns.
Wolper said four funds track the MSCI Index — two mutual funds and two ETFs.
Vanguard offers Vanguard Emerging Markets Stock Index Fund (VEIEX) and Emerging Markets ETF (VWO) , which together have $10.6 billion in assets.
There is also the $21 billion iShares MSCI Emerging Markets Index ETF and the $218 million Northern Emerging Markets Equity Fund (NOEMX) .
Gus Sauter, chief investment officer at Vanguard, said the firm is “investigating” how it would handle any required sell-off of South Korean assets. Its largest Korean holding is Samsung Electronics Ltd. (SSNG.Y) The funds’ second-largest holding is Israel’s Teva Pharmaceutical Industries Ltd. (TEVA) .
The simplest way to dispose of assets, Sauter noted, would be through a sale to sister funds that track the index to which Korea would be added, such as Vanguard Developed Markets Index Fund (VDMIX) . One problem might be whether Korea allows in-kind transfers — sales between funds in the same firm. If that’s not permitted, Vanguard would have to sell roughly $1.2 billion worth of Korea holdings into the market.
Once the assets are sold, the fund would immediately buy stocks from countries still in the index, Sauter said.
“You’re just changing seats at the table,” he said. “There’d be heavy trading on the day the change was made, but there shouldn’t be dislocation in the markets.”
“It shouldn’t be too much of a shock to the markets because that money will be spread across several countries,” Wolper added.
Sauter added that liquidity in emerging markets is a concern, but finding stocks to buy shouldn’t be too difficult because the more liquid markets have a larger share of the index.
Active managers’ approach
The change might be trickier for active managers, who could find themselves without a double-digit chunk of their portfolio. “For some managers it might be hard to find [enough] other companies that they like,” Wolper said.
If South Korea was upgraded, at least one actively managed fund would unload its related country holdings.
Todd Henry, portfolio specialist who works on T. Rowe Price Emerging Markets Stock Fund (PRMSX) , said it would likely divest from Korea. As of Feb. 28, about 9% of the fund’s assets were in Korean stocks, according to T. Rowe’s Web site.
“If Korea moves to developed market status, it’s likely that our clients would be getting exposure to it from their developed markets or global managers,” Henry said.
Managers at Templeton Developing Markets Fund (TEDMX) , however, might not sell their Korea exposure at all, said Stacey Johnston, spokeswoman at Franklin Resources Inc. (BEN) .
“Our stock selection and portfolio allocation decisions are not driven by changes made in the indexes,” Johnston said.
She pointed out that the fund’s prospectus allows for 20% of its assets in developed market countries, which Morningstar’s Rocco said is quite common for emerging markets funds, though the amount given to developed markets varies.
Rocco said it’s unlikely there’ll be dramatic selling or buying even if MSCI makes the proposed changes. “For those who own an actively managed emerging market fund, I don’t think it’ll be a big deal,” he said.
T. Rowe’s Henry said country upgrades might in fact benefit investors because they rid the index of the more efficient markets. An index of less-efficient markets could help active managers, he added, because they’d have the chance to differentiate themselves from rivals.
Odds for change
Some of the potential changes are due to a structural review at MSCI, Briand said. The firm launched its Frontier Markets Index in November 2007, giving it a new category option. As a result, he said, “We reviewed and changed the criteria and definitions” of country classifications.
Shifts made since June include: downgrading Jordan to frontier markets status because of the small size of the market and lack of liquidity; removing Pakistan from the Emerging Markets Index (it will be added to the Frontier Markets Index in May), and downgrading Argentina to frontier market status because of capital-flow restrictions (it’s still in the Emerging Markets Index).
“This may seem like a lot, but some of the countries are very small,” Briand said. Argentina, for instance, is just 0.1% of the Emerging Markets Index. By contrast, he said, in 2006 when Russian oil company Gazprom (OGZPY) floated more stock, its share of the index grew by roughly 4%.
How likely are the proposed moves? Consultations about the changes are due to be completed in June, Briand said, though he was non-committal about their outcome.
In a preliminary assessment in December, he said, there were “a number of open questions” regarding Korea, particularly its currency and lack of clarity about authorities’ plans for the country’s markets. As for Israel, the main concern is the relatively short settlement cycle for stocks on the Tel Aviv Stock Exchange.
Briand added that while the UAE’s case remains open, an upgrade for Qatar and Kuwait is unlikely this year because their markets lack accessibility.
“There would need to be a lot of progress in a short period of time,” he said.