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ETF Specialist

Yet More Changes for Emerging-Markets Indexes

The composition of emerging markets continues to evolve.

The increased inclusion of China A-shares, Saudi Arabia's newfound acceptance, and South Korea's dual identity are driving some notable changes to index-tracking emerging-markets funds.

The China A-Share Market
China's ascendance in emerging-markets stock indexes 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 indexes 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.

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 programs, 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 recognize 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 indexes 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.[1] The two most prominent funds affected by this change are  iShares MSCI Emerging Markets ETF (EEM) and  iShares Core MSCI Emerging Markets ETF (IEMG). Both funds had less than 1% of their assets allocated to China A-shares at the end of March 2019. Each fund has a Morningstar Analyst Rating of Bronze.

Other index providers have also started to recognize the role of China A-shares in the emerging-markets universe. FTSE Russell and S&P Dow Jones Indices have announced plans [2,3] 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. Bronze-rated  Schwab Emerging Markets Equity ETF (SCHE) tracks the FTSE Emerging Index, while SPDR Portfolio Emerging Markets ETF (SPEM) targets the S&P benchmark. Neither fund held China A-shares as of March 2019.

I would be remiss for not mentioning the largest (by assets under management) emerging-markets fund that Morningstar rates. The $85 billion  Vanguard FTSE Emerging Markets ETF (VWO) has tracked a benchmark that includes large-, mid-, and small-cap China A-shares since November 2015. So, the previously mentioned updates won't affect its portfolio. China A-shares represented just over 4% of its assets as of March 31, 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.[4] 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 U.S. dollar. So including these stocks does not introduce additional currency risk to the index.

Emerging or Developed?
 Schwab Fundamental Emerging Markets Large Company ETF (FNDE) saw a considerable shift in its country composition during its March rebalance.

FNDE tracks a fundamentally weighted index built by FTSE Russell and Research Affiliates. Prior to March 18, 2019, it selected stocks from the Russell Global Index. But that benchmark will be decommissioned, prompting a change to the index underpinning the fund. The index's starting universe switched to the FTSE Global All Cap Index at its March 18 rebalance.

This change resulted in a shakeup of the fund's country composition that was centered around South Korean stocks. The outgoing Russell benchmark classified South Korea as an emerging market, while the incoming FTSE index assigns it developed-markets status. At the rebalance, FNDE's 19% stake in South Korea went to nil, while stocks from other major markets in the emerging-markets sphere, namely China, Russia, and Taiwan, picked up the slack. 

The transition to a new starting universe and the exclusion of Korean stocks doesn't change the fund's ratings. Ultimately, the fund's fundamental weighting approach is the driver behind our Neutral Process Pillar rating and Analyst Rating of Neutral. This is because fundamental weighting causes the portfolio to overweight risky parts of the emerging-markets universe. Specifically, stocks from the volatile energy and materials sectors make up one third of its holdings. For comparison, stocks from these sectors collectively represent 17% of the cap-weighted FTSE Emerging Index.

The Big Picture
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 capitalization. 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 indexes will continue to change, sometimes rapidly, to reflect the evolution of their economies.

1) MSCI. February 2019. "Further Weight Increase of China A Shares In MSCI Indexes."

2) FTSE Russell. September 2018. "FTSE Russell promotes China A Shares to emerging market status."

3) S&P Dow Jones Indices. December 2018. "S&P Dow Jones Indices' 2018 Country Classification Consultation Results."

4) MSCI. June 2018. "Results of MSCI 2018 Market Classification Review."

Daniel Sotiroff does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.