Ticking Time Bomb Under EEM

by on June 14, 2010 | ETFs Mentioned:

In recent weeks, increased international scrutiny over Israel’s blockade of Gaza and conflicts with vessels carrying aid to the impoverished area have overshadowed a rather unique economic accomplishment. Israel was recently reclassified from “emerging” to “developed” market status by index provider MSCI Barra, the firm responsible for creating and maintaining the benchmarks behind many popular exchange-traded products.

The upgrade had been in the works for some time; MSCI first announced that Israeli markets met all the qualifications for developed status last June. Such an announcement is undoubtedly a positive development for a country that has made great strides in improving quality of life indicators and market transparency while rooting out corruption. So the impact on Israeli stocks as the news broke was at first a bit perplexing; the iShares MSCI Israel Investable Market Index Fund (EIS) slid more than 4% when the initial announcement was made, a far bigger loss than most global equities endured on the same day. But upon further review, the slide made a lot of sense. The upgrade meant that Israeli equities would be cast out of funds linked to the MSCI Emerging Markets Index, a benchmark that is currently the basis for two of the largest five ETFs by total assets.

In a survey conducted by a Deutsche Bank analyst, 78% of institutional investors replied that the move would be a negative development for the Israeli market, while 22% thought it would be neutral.

The events highlighted one of the interesting nuances related to the tremendous rise in popularity of ETFs. These funds are designed to react to changes in the market value of the underlying security. But in the case of Israel’s upgrade, the tail seemed to be wagging the dog; Israeli stocks reacted to a change in the composition of an index.

This phenomenon is nothing new. At every rebalancing of the Dow Jones Industrial Average, speculation over potential new members swirls, since inclusion in the Dow usually leads to a nice one time boost from a wave of institutional buying. But as the use of indexing strategies has become more widespread, the impact of changes to benchmark compositions has become more pronounced.

Looming Issues?

Based on the equity market performances observed immediately after Israel’s upgrade, upcoming developments could create a major return drag on some of the most popular ETF products. Taiwan and South Korea are both poised to follow in Israel’s footsteps in the not-so-distant future, graduating from emerging status and thereby being removed from the MSCI Emerging Markets Index.

In its press release announcing Israel’s upgrade, MSCI noted that both countries already meet “the economic development as well as the size and liquidity requirements” laid out for developed economies. But minor hurdles, such as a lack of full convertibility of the local currencies, remain as obstacles to developed status. In terms of literacy rates, per capita GDP, and other economic indicators, South Korea and Taiwan are more similar to the U.S. than they are to the BRIC. For all practical purposes, they are developed markets stuck in emerging status on a few technicalities.

The relative weightings afforded to South Korea and Taiwan compared to Israel in exchange-traded products are wildly different. Israel formerly made up about 3% of the MSCI Emerging Markets Index, while Taiwan and South Korea combine to account for about  25% of the index tracked by the Vanguard Emerging Markets ETF (VWO) and iShares MSCI Emerging Markets Index Fund (EEM). Those two funds have aggregate assets in excess of $50 billion, meaning that an index reconstitution could cause some significant reshuffling.

ETF Alternatives

MSCI Barra is scheduled to announce the results of its 2010 Market Classification Review on June 21, and traders around the world will be watching with intense interest. If either South Korea or Taiwan is upgraded, expect a lot of activity. If both get the call-up, markets could see a day of unprecedented activity as investors attempt to front-run rules-based index products.

For investors concerned about the impact of the upcoming announcements on asset values of large emerging markets ETFs, there are a number of interesting alternatives. There are currently three BRIC ETFs that offer exposure to the “big four” emerging markets of Brazil, Russia, India, and China. These economies could be among the beneficiaries of a reshuffling; their allocations in emerging market indexes could jump to fill the voids left by outgoing members. The Claymore/BNY Mellon BRIC ETF (EEB) is the largest of this group, with assets of more than $900 million.

Another interesting option is the “pure play” emerging markets ETF from Emerging Global Advisors. The Emerging Markets Composite Titans Index Fund (EEG) is linked to a Dow Jones index that doesn’t include the quasi-developed nations of South Korea and Taiwan, but is more diversified from a country perspective than BRIC ETFs (South Africa, Mexico, Malaysia, and Indonesia make up about 25% of holdings).

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Disclosure: No positions at time of writing.