The argument for a broad-based market capitalised indices ticks several boxes for investors and the lure of the market doing the heavy lifting appeals to many more, despite the inevitable bumps in the road that come with emerging markets.
However, recent world events have turned these bumps into potholes which are investors are finding it increasingly difficult to avoid as they find themselves bound to the definitions of index providers.
The heavy hand of China – currently experiencing an array of considerable volatility – in emerging market indices has highlighted concerns around the way emerging market indices are dominated by a handful of larger markets and the cap-weighted methodology as we know it.
At one point last year, China accounted for 41.5% of the $2.7bn Vanguard FTSE Emerging Markets UCITS ETF (VFEM), which classifies South Korea as a developed market. It has since fallen back to 33% due to the recent foreign in-vestment flight, however, still represents a dominant portion of the index.
The iShares Core MSCI EM IMI UCITS ETF (EIMI), which classifies South Korea as an emerging market, has seen its China weighting shrink from 31% to 25.7% over the same period.
Despite China’s recent woes, ETF issuers have picked up on investors' unease, with the proliferation of products offering alternative growth areas over the past year as investors signal concerns over China’s dominance. Last November, Amundi launched Europe’s first ETF offering an ESG overlay on an emerging-China product, the Amundi MSCI EM ex-China ESG Leaders Select UCITS ETF (EMXG).
Two other emerging market ex-China ETFs are the Lyxor MSCI Emerging Markets Ex China UCITSETF (EMXC) and the iShares MSCI EM ex-China UCITS ETF (EXCH) are also listed in Europe. Despite China’s dominance, Mike Oranzo, senior director of global equity indices at S&P Dow Jones Indices, said it is worth remembering the country is still structurally underrepresented in emerging markets.
“Because of foreign investment restrictions on China A-Shares are still represented at partial inclusion factors,” he says. “Despite China being third of our S&P Emerging BMI, it would be much larger if you are looking at things from an unconstrained standpoint. “With this in mind, is it time for a fundamental restructure of emerging market cap-weighted indices?
Changes on the horizon
Oranzo says emerging market indices have evolved to incorporate more choices for investors, however, he does not see a fundamental shift in the way indices are constructed. “We have seen a bit more expansion in emerging markets that have become larger, more liquid with interest moving away from broader exposures,” he continues.
“This could be for emerging market small-caps as a standalone or just looking at the all-cap broader exposures. There are more indices within core benchmarks and more providers looking deeper at index construction.”
He adds there is a movement toward different themes within emerging markets and more nuanced exposures.
“There is certainly a trend towards new and different themes and looking segmenting the market in different ways. A lot of the same themes we see growth into in other areas of equities and asset classes, we are likely to see come through emerging market exposures in the coming years,” he says.
While market capitalisation has the largest impact on the weighting in emerging market in-dices, Dimitris Melas, head of research at MSCI agrees it will not be refined in the near future.
Out of the three pillars that define emerging markets – economic development, size and liquidity and foreign investor accessibility – he points to the economic development as the most likely to be refined. Currently, the category relies on the gross national income (GNI) per capital methodology which calculates the average before-tax income of a country’s citizens, published by the World Bank.
“An area where perhaps we could see in the future refinement is the way we assess economic development. At the moment we use criteria which rely on GNI per capita,” Melas says. “But there may be other developments that we could see becoming important and this is perhaps where we see some evolution.”
An additional change that does not affect the construction, but speaks to the challenge of abroad emerging market strategy, is the beefing up of governance teams to deal with the market impact of Russia’s invasion of Ukraine for example.
Oranzo says: “There is an increasing complexity of the landscape. We have seen specific security level sanctions, and we must be very close to monitoring our operations and governance teams around that. If there are major governments sanctioning securities, and you want your end index to be investable, we need to take that into account and be very careful with it.”
The data explosion
While a tweak of market-cap-weighted emerging market indices may be the only changes on the horizon, there are more existential forces at play more aligned to the growth of thematic indices which could come to define index construction in the future.
A company’s inclusion, particularly in a value-based index, has typically been measured exclusively on market data – earnings, price to book ratio and volume – but a rise in alternate data sources has changed the game. “Recently we have seen an explosion in what we call alternative data sources,” Melas explains.
“These are things such as news reports, company calls with analysts, social media postings information available through social media and even satellite imagery.”
He says these unstructured data sources can not be analysed in a computer programme but require new modelling techniques such as machine learning to be captured by index providers.
“These allow index providers to capture themes and thematic strategies through machine learning technologies. In the past, you would rely only on fundamental investors who would combine basic sources of information,” Melas adds.
“But we are starting to see more and more thematic strategies being offered through indices, it is an area of innovation that applies across the board, not only on emerging markets.”
This article first appeared in ETF Insider, ETF Stream's monthly ETF magazine for professional investors in Europe. To access the full issue, click here
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