• A handful of dominant commercial index providers enjoy outsized influence over the emerging market asset class. Notably, they are doing so while balancing competing objectives.
• These objectives include market representation, cost efficient and rapid replication, and sometimes pressure to represent “acceptable investment standards” to government officials internationally. What may be sidelined is an accurate picture that fairly represents the known and less-trafficked segments of the emerging markets.
• Unfortunately, subjective judgements appear to be inescapable for index providers – for example, in defining what is “replicable” or even what constitutes an “emerging market.”
• Emerging market index providers’ pursuit of scalability and replicability has taken precedence over fidelity to the fundamentals of the underlying markets.

At the heart of the emerging market (EM) asset class lies a conundrum. The asset class aims to track the financial markets of certain “developing nations” that have progressed beyond the initial stages of economic development (often referred to as frontier markets), but that do not yet enjoy the levels of industrialization, economic output or financial market sophistication achieved by wealthier nations (often referred to as developed nations). Thus, the emerging markets are bound by a nebulous standard: not over-developed, but developed enough to be deemed investable for certain purposes.

Emerging markets are generally understood to include between 24 and 26 countries; not all parties agree on the same countries – and thus the boundaries of the EM depend on whom you might ask.¹ Prominent definitions of the EM suggest that the asset class encompasses countries that represent 34% of global gross domestic product (GDP) and 31% of global equity market capitalization.²³ The countries that comprise the asset class are diverse: there is no objective set of development standards, government systems, or financial metrics that unites them. This inherent subjectivity in the label has given index providers an important role to play, as their efforts have helped to standardize the asset class while providing benchmarks to gauge the performance of various EM investment products and strategies. During the past two decades, those same indices have also served as the foundation for a host of passive investment products.

If the relative scale of benchmarked investment products offers any indication, the numbers suggest that index-based emerging market products have successfully met a need. A 2018 study by the Bank for International Settlements (BIS) indicates that 30% of EM assets under management (AUM) were passively benchmarked, more than double the proportion from 2007.⁴ This number almost certainly understates the true scale of indexing, given the prevalence of shadow-indexing among some nominally active funds, and the passive strategies prevalent among pension and insurance funds.

In this series, A Tale of Two Indices, we explore the following questions:

• What do EM indices look like?
• How are they designed, and what are their objectives?
• In what manner do they excel at meeting their objectives, and what are their limitations?

To accomplish this, we will first need to introduce terminology that frames alternative approaches to measuring markets. Establishing clear definitions will help us to understand the sometimes diverging expectations market participants have of their benchmarks, and contextualize the choices by index providers to either accept or reject these expectations.

Two Possible Approaches: Positive and Normative

To borrow terminology from the field of economics, there are two philosophies toward measurement.⁵

Positive statements (sometimes referred to as objective statements) aim to describe “what is” in a factual and quantifiable way. In economics, positive statements eschew value judgments in favor of hard measurements. They are commonly expressed as hypotheses that can be tested against data. For instance: “A 10% increase in minimum wage would lead to a rise in unemployment” is a data-based statement that is testable and makes no claim as to whether a minimum wage increase is “right” from a policy perspective.

Normative statements (sometimes called subjective statements) express value judgements to convey “what ought to be.” Normative statements in economics may be expressed as policy recommendations that reflect a specific point of view. For example: “The governments should allow free markets to determine wages” is an opinion and a normative statement.

When defining an emerging market index, a positive index might introduce an objective basis for weighting companies (for example, market capitalizations or reported revenues) and avoid filters for subjective assessments of quality or safety. A normative approach might be more selective than a positive one, considering factors such as minimum liquidity, governance and ease of market access when determining company weightings. A normative index may restrict or even eliminate exposure to certain markets that lack what the index providers define as adequate governance standards

When it comes to equity indices, the two approaches have relative advantages and trade-offs.

A positive approach yields greater objectivity and inclusivity, and typically maximizes representation. A purely positive index is probably the most consistent with the idea of passive investing: buying a comprehensive sampling of stocks weighted objectively by economic importance.

As a positive index based on market capitalization does not filter for current trading constraints or estimates of float, it directly reflects where capital markets have recognized value creation. One critique of the positive approach – and the reason the major index providers have not pursued it – is that the resulting benchmark is costly, time-consuming and difficult to replicate, especially if hampered by market restrictions or lower liquidity.

A normative approach acknowledges today’s market constraints and may de-emphasize or exclude markets that do not meet pre-determined investability standards (defined as a combination of float and investor access). To be successful, normative indices – which include today’s commercial indices – need to be broadly accepted by manufacturers of passive, tracker products. To do so, commercial indices must have well-defined standards for efficient replicability and scalability – thereby lessening the complexity and cost of manufacturing another unit of a passive product.

Passive investment products also work readily with indices that de-emphasize companies with restricted access or flawed shareholder protections, and this saves investment firms the considerable expense of developing nuanced decision criteria and market access capabilities in-house. In certain instances, the largest index providers have historically been able to use their influence to engage with emerging market policy makers on behalf of their investor-clients to promote higher transparency and governance standards.

Some critics of commercial indices express doubt over the ability of a few, for-profit index providers to effectively represent and safeguard the market’s interests. The index providers need to meet a commercial objective – ease of replication at scale – and what may be lost is a more accurate picture that fairly represents the less-trafficked or harder-to-access segments of the market.

The major index providers have had to negotiate a balance between accurately and objectively representing the market (the positive approach), while holding back some weightings for subjective reasons (normative approach).

On the former, Mark Makepeace, the head of index provider FTSE Russell, explained: “We’re setting the minimum standards that investors generally will accept, and our role is to build consensus amongst that investor community as to what that minimum standard should be.”⁶

At the same time, index providers self-describe as impassive market gauges. MSCI’s Index Policies document states, “MSCI indexes aim to accurately and objectively measure performance of a market or economic reality as represented by the investment opportunity set based on a market, market segment, theme, or investment strategy.”⁷

The gaps between the objective and subjective indices (explored further in Part II) stem from inherent difficulties in reconciling a quantitative depiction with more subtle definitions of investability.

The Index Providers: A Few Leading Players

Index providers comprise a handful of large, for-profit firms including FTSE Russell, MSCI, S&P Dow Jones, and Bloomberg. Within emerging market equities, the two dominant indices are the MSCI Emerging Markets Index and the FTSE Emerging Markets All Cap China A Inclusion Index. Figure 1 compares the two leading EM indices.

Note: MSCI also produces an all-capitalization emerging market index, MSCI Emerging Markets Investable Market Index (IMI) that is not as widely followed as its flagship EM Index.⁸ Throughout this paper, MSCI Emerging Markets Index refers to MSCI’s flagship emerging markets index rather than the MSCI EM IMI or MSCI’s capitalization-specific EM indices.⁹

The two EM indices’ methodology documents point to a hybrid approach on the normative-positive spectrum. Both indices start with objective market capitalization data, then layer on subjective free float estimates and normative screens for what an index “should” look like, and ultimately rely on teams to handle trickier aspects of index implementation and rule changes.

Specifically, MSCI’s Index Policies identify three requirements: “representativeness” (benchmarks should have accurate coverage depth within the target financial market); “replicability” (non-domestic investors should be able to passively reproduce the benchmarks), and “efficiency” (benchmarks need to be stable and simple enough to keep replication costs low).⁷¹⁰ Day-to-day activity is rules-based, and MSCI relies on its Equity Inclusion Committee to periodically assess changes to index methodologies and implementation.

Similarly, FTSE Russell screens out stocks that either have been placed on exchange surveillance, or fail to meet FTSE-determined minimum levels of liquidity, trading activity, or investability.¹¹ FTSE has several External Advisory Committees that provide human judgement on changes including rule amendments and country classifications.

Perhaps the clearest example of the normative process is the indices’ classifications of countries as frontier, emerging, or developed. Some passive EM investors may still believe that they are buying a representation of a certain economic development profile, but the final determinants of what ends up in the EM index are often administrative. For example, MSCI’s 2018 market accessibility review for Kuwait scored a long list of qualitative factors, including information flow, ease of investor registration and account set-up, and standards of processes for clearing and settlement.

What this means for benchmarking investors is that the “active” portfolio decisions of country inclusion and weighting are made by index providers. The classifications matter tremendously for countries’ stock markets, as a change from frontier to emerging market status can generate billions of dollars’ worth of asset flows. For this reason, government officials from Peru lobbied MSCI to keep the country’s domestic equities within MSCI’s Emerging Markets Index in 2015.¹² The addition of Chinese A-shares in 2018 was accompanied by rumors that Chinese officials had pressured MSCI with promises of business opportunities and threats of withdrawn pricing data access.¹³

Constructing an Objective Benchmark

Before we can make concrete normative and positive index comparisons, we need to introduce a positive benchmark. An aim of Part II is determining whether statistical bias is present in commercial indices. In statistics, bias exists when a sample statistic systematically over- or under-estimates a parameter (i.e. a measurable characteristic) relative to the population.¹⁴ In our case, the test is whether the indices manifest systematically different investment exposures compared to the population of emerging markets equities. Commercial index providers exclude certain stocks from their indices for limited accessibility, which makes sample selection a potential source of bias.¹⁵

For the positive EM benchmark, Seafarer has assembled a collection of issuers across 26 EM countries that have a market cap of at least 100 million USD-equivalent.¹⁶¹⁷ Equities are weighted at 100% of their capitalization, which implies no discounts for float or access restrictions. To keep comparisons relevant to the largest number of investors, the MSCI Emerging Markets Index will represent the normative index. There are of course many more EM benchmarks in the market, but the MSCI Emerging Markets Index is the most widely used with over 1.84 trillion USD-equivalent of benchmarked AUM.¹⁸ Figure 2 compares the normative MSCI EM Index with a positive EM benchmark, assembled by Seafarer.

For comparison, as of December 31, 2019 the MSCI USA Index had a market capitalization coverage of 82% – index capitalization was $28 trillion compared to $34 trillion of aggregate capitalization from U.S. companies, as shown below in Figure 3.¹⁹ 55% of EU market capitalization was represented in the MSCI EU Index.

Reference indices are MSCI Emerging Markets, MSCI US, and MSCI Europe. Total EM and EU equity market capitalizations are calculated as the sum of capitalizations for companies trading above $100 million as of December 31. EM equity market capitalization is calculated as the sum of capitalizations for 26 countries included in the MSCI EM Index: Argentina, Brazil, Chile, China, Colombia, Czech Republic, Egypt, Greece, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Pakistan, Peru, Philippines, Poland, Qatar, Russia, Saudi Arabia, South Africa, Taiwan, Thailand, Turkey and United Arab Emirates. US equity market capitalization is from the Bloomberg United States Exchange Market Capitalization USD Index as of December 31. EU equity market capitalization is calculated as the sum of capitalizations for 15 developed European countries included in the MSCI EU Index: Austria, Belgium, Denmark, Finland, France, Germany, Ireland, Italy, the Netherlands, Norway, Portugal, Spain, Sweden, Switzerland and the UK.

Sources:  Bloomberg, FactSet, Seafarer.

Summary of Part I and Preview of Part II

The leading index providers have aided broader market participation in the EM, while amassing such large followings that their decisions can reshape the fortunes of countries. The largest indices have downplayed their active role and made efforts to codify their weightings in numerically-expressed rules that are shared with the market. However, normative judgements are inescapable for commercial index providers – even in their efforts to define what is “replicable” or “an emerging market.”

In Part II of A Tale of Two Indices, we continue our discussion in quantitative terms, by making comparisons of the normative and positive indices along key investment facets.

1. Two prominent definitions of the EM asset class are advanced by two index providers, MSCI and FTSE/Russell. Both firms undertake periodic reviews, during which they determine (and as necessary, re-classify) the constituent national members of their respective EM indices that are designed to track the asset class. MSCI’s latest determination, as of March 2019, includes 26 nations; FTSE/Russell’s latest determination, also as of March 2019, includes 24 nations, with some determinations that differ from MSCI.
2. “GDP (current USD) in 2017,” The World Bank.
3. Bloomberg, Seafarer. Global equity universe contains all companies with a minimum USD 100 million market capitalization. As of 31 December 2019.
4. Vladyslav Sushko and Grant Turner, “The implications of passive investing for securities markets,” BIS Quarterly Review, March 2018.
5. Milton Friedman, Essays in Positive Economics (University of Chicago Press, 1953).
6. Tracy Alloway, Dani Burger, and Rachel Evans, “Index Providers Rule the World—For Now, at Least,” Bloomberg Markets, 26 November 2017.
7. “MSCI INDEX POLICIES,” MSCI Inc., February 2019.
8. As of 31 December 2019, the MSCI Emerging Markets Investable Market Index (IMI) had 3,057 constituents, a median market cap of USD 1,850 million, and an average market cap of USD 7,608 million.
9. “MSCI Emerging Markets Index”
10. “Consultation on Potential Ideas for Index Stability and Replicability Enhancements,” MSCI, September 2011.
11. “FTSE Global Equity Index Series,” FTSE Russell, February 2019.
12. Colin Post, “Ruling signals MSCI likely to keep Peru as ‘emerging market’,” Peru Reports, 12 May 2016.
13. Mike Bird, “How China Pressured MSCI to Add Its Market to Major Benchmark,” The Wall Street Journal, 3 February 2019.
14. “Statistics Dictionary: Bias,” Stat Trek.
15. “Statistics Dictionary: Survey bias,” Stat Trek.
16. 26 EM countries as defined by MSCI as of 31 December 2019.
17. Methodology note: we define an objective benchmark as comprising companies with an equity market capitalization of at least USD 100 million in 26 EM countries, as defined by MSCI. Argentina, Brazil, Chile, China, Colombia, Czech Republic, Egypt, Greece, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Pakistan, Peru, Philippines, Poland, Qatar, Russia, Saudi Arabia, South Africa, Taiwan, Thailand, Turkey and United Arab Emirates.
18. “MSCI — A LEADER IN EQUITY INDEXES,” MSCI
19. Sources: Bloomberg index WCAUUS for total US market capitalization; Index data based on MSCI USA Index, Bloomberg.

MSCI USA Index is an index designed to measure the performance of the large- and mid-capitalization segments of the U.S. market. Index code: MXUS. MSCI China Index is a free float-adjusted equity index that tracks large- and mid-capitalization companies across China A-Shares, H-shares, B-shares, Red chips and P chips and foreign listings (e.g. ADRs). Index code: GDUETCF and MXCN. MSCI Emerging Markets Investable Market Index (IMI) is an all-cap index that represents emerging market countries. Index code: MXEFIM. FTSE Emerging Markets All Cap China A Inclusion Index is a market capitalization weighted index representing the performance of large-, mid- and small-capitalization stocks in emerging markets. Index code: FQEACR. MSCI Emerging Markets USD Total Return Index, Standard (Large+Mid Cap) Core, Gross (dividends reinvested), USD is a free float-adjusted market capitalization index designed to measure equity market performance of emerging markets. Index code: GDUEEGF. MSCI Emerging Markets Currency Index is an index that tracks the performance of emerging market currencies relative to the U.S. dollar. The Currency Index measures the total returns of the currencies of countries in the corresponding MSCI equity index (i.e. MSCI Emerging Markets Index). Index code: MXEF0CX0. MSCI Emerging Markets Index is a free float-adjusted market capitalization index designed to measure equity market performance of emerging markets. Index code: MXEF. The MSCI Europe Index captures large- and mid-cap representation across the European developed markets equity universe.  Index code: MXEU. The Bloomberg United States Exchange Market Capitalization USD Index is a total capitalization index representing actively traded, primary securities on U.S. exchanges.  Index code: WCAUUS. It is not possible to invest directly in an index.

As of December 31, 2019 the Seafarer Funds owned no shares in the entities referenced in this commentary.

The views and information discussed in this commentary are as of the date of publication, are subject to change, and may not reflect Seafarer’s current views. The views expressed represent an assessment of market conditions at a specific point in time, are opinions only and should not be relied upon as investment advice regarding a particular investment or markets in general. Such information does not constitute a recommendation to buy or sell specific securities or investment vehicles. It should not be assumed that any investment will be profitable or will equal the performance of the portfolios or any securities or any sectors mentioned herein. The subject matter contained herein has been derived from several sources believed to be reliable and accurate at the time of compilation. Seafarer does not accept any liability for losses either direct or consequential caused by the use of this information.