Senior figures mull implications of MSCI reclassification

MSCI is set to announce if it will upgrade Korea and Taiwan to developed-market status. We discuss the likely impact of the move with active managers, heads of ETF businesses and a consultant.

Benchmark-aware portfolio managers around the world are waiting eagerly to hear whether MSCI is going to reclassify Korea and Taiwan to developed-market status this week.

The index provider is due to make its pronouncement tomorrow, and given that the two nations represent 14.8% and 11.6% of the MSCI Emerging Markets Index respectively (behind only China and Brazil in weighting), positive decisions would herald significant changes in capital flows. The resulting rebalancing of ETFs would be of the largest on record, it has been reported.

AsianInvestor spoke to two active managers, two regional heads of large ETF businesses and a consultant to institutional investors to canvass their opinions on the potential implications and key beneficiaries of such a move.

JP Morgan recently published research saying it expects net inflows of $7 billion into Korea and $4.5 billion into Taiwan were both markets to be upgraded.

But Peter Ryan-Kane, Asia-Pacific head of portfolio advisory for consultancy Towers Watson, points out that whether reclassification takes place or not, it does not change the amount of stock on issue or the number of companies listed on both exchanges.

“What it might do is change the mix of who owns them,” he states. “But in terms of there being huge money inflows, from a technical point of view that is not possible because there is nothing to buy that is not already owned.

“The flow may change, with ETFs and others needing to recalibrate their portfolios as Korea and Taiwan go into another index, but the amount of money allocated to emerging markets does not actually change that much.”

Peter Elston, investment strategist from Aberdeen Asset Management, expects emerging markets to see an outflow while developed will see an inflow, although the net effect would not be that great.

“There will be a net inflow because I suspect there are some investors who will only invest in developed markets, but the effect is not as big as perhaps people think," he says. "It would only be a very short-term effect.”

On the question of whether there would be a large influx of money into Korea and Taiwan, Marco Montanari, Asia head of Deutsche Bank’s ETF platform, also says it would work both ways.

“What would go out because of exclusion from the MSCI Emerging Markets Index could be similar to what goes in because of inclusion in the MSCI World Index. The two may offset each other,” he says.

Still, he acknowledges the risk of a sizeable outflow from emerging market ETFs. “But I would expect this kind of situation to be anticipated by the market and to happen in a smooth way,” he adds. “A lot will depend on how the information is disclosed by MSCI.”

Frank Henze, Asia-Pacific head of ETFs at State Street Global Advisors, rubbishes the notion that reclassification is solely an ETF issue, given that many passive and active mutual funds are benchmarked against the MSCI Emerging Markets Index.

“I think it is fair to say that the market in general will be impacted with regards to selling and buying or switching securities from emerging-market portfolios into developed-market portfolios,” says Henze.

“The level of activity will be quite substantial, but to a certain degree this would be like a big index rebalancing. The mechanics and implications are the same, it’s just there would be more to be churned.

“The reshaping of the Emerging Markets Index would be significant and it would incur trading costs as a result. But there is very little you can do about that.”

Henze points out that a lot of investors in Asia do not regard Korea and Taiwan as emerging markets anyway and suggests many would welcome reclassification “because it would mean a stronger focus on emerging economies in many ways”.

Certainly the changes, which would likely have a long lead-time and not be implemented until 2012, would be most challenging for emerging-markets managers.

“You are losing a quarter of your opportunities, so in terms of their universe they are going to have to work harder in the other 75% to find those opportunities,” reflects Stuart Rae, CIO of Pacific Basin Value Equities.

He notes that US clients tend to see the world as US equities, international developed and international emerging, while in Europe there is more of a geographic model adopted where clients go for Asian, European or US equities.

Rae suggests reclassification might prompt a move towards more geographic management of assets. “You might see a shift away from this developed- and emerging-market structure towards a more geographic structure,” he says.

In terms of immediate beneficiaries within emerging markets, he points to China and Brazil as the two biggest, along with countries such as India, Russia and South Africa all getting up-weighted and potentially seeing inflows.

Rae expects the chief beneficiary to be China among less benchmark-aware managers. “A lot of stocks in Korea and Taiwan have some connection to China, so you would probably find a lot of people looking to have more Chinese ideas in their portfolios,” he says.

He also notes that emerging markets managers would have to find their tech exposure elsewhere, given that a benchmark without Korea or Taiwan in it would have a lot less of a tech flavour. Managers would also have to look elsewhere for exposure to industrials, chemicals, shipbuilding and heavy engineering.

However, he adds that at this stage it is hard to gauge the impact on equity markets in Asia and emerging nations, given the differing requirements of both value and growth managers.

But, if one thing is abundantly clear, it is that none of the industry figures AsianInvestor spoke to actually expects these reclassifications to take place, despite the fact that Korea and Taiwan tick most of the boxes in terms of market size, liquidity and economic development.

The lingering hang-ups, it seems, mostly revolve around currency. The Taiwan dollar, for instance, is not a freely convertible currency, while Korea does not have a strong offshore won market and so does not have a fully developed currency market.

Says Elston of Aberdeen: “MSCI points to requiring support from institutional investors and I suspect that many of them are still saying exactly the same things that they were a year ago, namely that we still have this ID system [foreign ID registration], problems with Korea not having an offshore won market and limited trading hours of the onshore spot currency market.”

More contentiously, he added that Korea and Taiwan might themselves not actually want to be upgraded to developed-market status because of resulting increased expectations. “I suspect if they were asked, they would probably choose to stick with the emerging label.”

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