Steph Gan examines questions that are fundamental to the emerging market asset class: How are emerging market indices designed, and what are their objectives? In what manners do the benchmarks excel, and what are their limitations?
– Prevalent benchmark indices for the emerging markets have helped to standardize an otherwise unorganized asset class. Index providers have sought to make indices highly scalable and rapidly replicable so as to facilitate the manufacture of index-based products and defer any concerns regarding capacity constraints. This subjective emphasis on “scalability and replicability” has overshadowed efforts to create a benchmark that offers a high degree of fidelity to the underlying market structure of the emerging markets. Part I introduces a simple framework for understanding different approaches (subjective versus objective) to measuring markets.Part I: How to Design an Index for the Emerging Markets
– Using Part I’s framework of two possible approaches to measuring markets, Part II provides a series of comparisons between the normative benchmark (the flagship MSCI Emerging Markets Index) and an objectively quantified EM benchmark. Marked differences across country, capitalization, and industry exposures illustrate that benchmarking to a normative index under-invests in China and excludes the majority of small-capitalization constituents. Backward-looking capitalization-based indices, like the MSCI EM Index, might exclude or de-emphasize some of the industries and companies – and ultimately the opportunity for growth – that are associated with the developing world and its emergence.Part II: A Practical Comparison of Indexing Methods
Emerging market index providers’ pursuit of scalability and replicability has taken precedence over fidelity to the fundamentals of the underlying markets.