FTSE COUNTRY CLASSIFICATION REVIEW
In September, FTSE released the results of its annual country classification review, highlighting several ongoing developments in the emerging and frontier markets. FTSE’s country classification is reviewed annually by the Country Classification Committee, which determines whether each country should be characterized as developed, advanced emerging, secondary emerging or frontier. Economic significance and market investability drive the decision. To be classified as developed, markets must meet all the criteria, while the standards for advanced emerging, secondary emerging, and frontier are progressively less-stringent.
Following FTSE’s interim review in March that included no country classification changes, ten markets appeared on the “watch list” for further consideration in September. Of the ten potential changes, only two markets – Argentina and Morocco – were reclassified (Exhibit 1).
Argentina was demoted from frontier status due to its capital controls on foreign investors that limit investability. Morocco was demoted to frontier status from secondary emerging status due to liquidity concerns. These two changes will be effective in 2015. Additionally, two markets – Palestine and Latvia – were added to the watch list for potential classification as frontier markets. The resulting list of ten markets will be reviewed for changes in classification in September 2015.
Following the reclassification announcements, several differences remain between the country classifications of major index providers. Exhibit 2 shows notable examples. Some of the countries listed in Exhibit 2 are significant in size and can cause major exposure differences if not accounted for properly. For example, FTSE continues to classify South Korea as a developed market, yet it is one of the largest markets in the MSCI and Russell emerging markets indices. Additionally, for frontier markets investors, the differences in classification of Argentina, Kuwait and Qatar are significant, as each of these is among the largest frontier markets, where classified as such.
The next round of classification announcements in 2015 has the potential for a significant impact on global investors. In addition to several markets potentially moving among developed, emerging and frontier, most major index providers have begun to consider China “A” Shares and Saudi Arabia. These two large markets have historically been restricted to foreign investors. Both markets would be significant emerging markets if included, though foreign investment restrictions make such a reclassification in the next year unlikely and problematic.
EMERGING MARKET COUNTRY UPDATES
MSCI Reclassification of the United Arab Emirates (UAE) and Qatar
The reclassification of the UAE and Qatar by MSCI took effect at the end of May, with the two markets making up a combined weight of 1.15% in the MSCI Emerging Markets Index1. The decision to reclassify the two markets from frontier market status to emerging markets was announced in June 2013. In the year leading up to the reclassification, the UAE market returned 97% and Qatar returned 55%, far outpacing the MSCI Frontier Markets Index’s return of 29% and the MSCI Emerging Markets Index, which returned just 4%.
In the month following the implementation of the reclassification, both markets reverted and lost more than 20% in June 2014. Some of this reversion can likely be attributed to profit-taking following the reclassification, but each market was also under stress from other concurrent events. In Qatar, as allegations of corruption mounted, rumours circulated about the potential for the country to lose its bid to host the 2022 World Cup. In the UAE, a wave of investor worry about the property market followed declines in Arabtec, a large developer in Dubai that came under pressure after its CEO resigned. Both markets recovered much of their June losses in July, with the UAE returning 17% and Qatar returning 12%2.
As violence in Ukraine escalated over the course of 2014, several governments, including the United States and the European Union, introduced a variety of sanctions against Russian individuals and other entities. As a part of these sanctions, governments prohibited transacting new equity or certain types of new debt of specified companies, with a focus on the financial and energy sectors. Until the specified companies issue new equity, the sanctions should have a limited impact on equity portfolios. However, should any of these companies decide to issue equity (none have up to this point), they would likely be viewed as uninvestable, since it would be impossible to distinguish newly issued shares from existing shares. Index providers are reviewing the sanctions and their impact as the circumstances evolve and engage asset managers in a discussion of the appropriate treatment of Russian securities. That being said, it is likely that, should any of the listed companies announce share issuances, these companies would be removed from major indices that include Russian stocks.
Saudi Arabia to Open Equity Market to Foreign Investors
Saudi Arabia is not currently included in any major global indices because investment by foreigners outside of the Gulf Coast Council is currently prohibited. That is beginning to change, as Saudi Arabia’s Capital Market Authority (CMA) announced it will open the Saudi market for direct investment to Qualified Foreign Financial Institutions (QFFIs) in 2015. The QFFI program appears to be similar to China’s QFII program, which regulates foreign investment in the China A-Share market. The draft regulation released by the CMA suggested that banks, fund managers, brokerage, securities firms, and insurance companies could submit applications for QFFI status, though the CMA would also have to approve the underlying clients as well.
The draft also suggested further requirements related to the regulation, size and experience of applying firms. The CMA is also expected to impose foreign ownership limits, with the draft regulation suggesting that individual QFFIs may not own more than 5% of any given company, and the maximum that all QFFIs in aggregate may own would be of 20% of each company.
If such regulations are enacted, it is unlikely that major index providers would immediately classify the Saudi market as an emerging market. Instead, it is reasonable to expect Saudi Arabia to remain a stand-alone index, much like the status of China A-Shares today, until regulations are further loosened.
UN CLIMATE CHANGE SUMMIT – LOW CARBON INITIATIVE
The focus on climate change has been heating up around the world in the past couple of years. An unprecedented number of heads of state, government officials and more than 800 leaders from business, finance and society attended the UN climate change summit on 23 September 2014. The summit sought to crystallise a global vision for low-carbon economic growth and to advance climate action. The two largest takeaways were:
The “PRI in person” conference in Montreal followed shortly thereafter. This conference sought after signatories to the Montreal Carbon Pledge, an initiative where investors will measure and publically disclose annually the carbon footprint of their investment portfolios. The aim is to attract US$500 billion of portfolio commitment in time for the UN Climate Change Conference in December 2015.
Discussions have occurred for some time within the investment community about reducing fossil fuel exposure and stranded carbon assets. The focus has centred on scientific research stating that atmospheric CO2 levels must be kept under 450 parts per million. The world currently has carbon reserves up to five times higher than this limit, which has led organisations such as 350.org to call for mass divestment from certain portfolios. The near-meteoric rise of 350.org has been well-documented, with CNN calling it the “most widespread political activity in the planet’s history.”
However, whilst full divestment is unlikely, it has raised questions within the investment community about less-drastic options to reduce fossil fuel exposure. The strong investor interest has led to the creation of a flurry of funds and indices.
MSCI recently expanded its family of low-carbon products, offering two variants of a carbon reducing strategies (Exhibit 3).
With other index providers such as FTSE and S&P also providing low carbon options, the continued development and growth of these products is an important milestone for investors in the shift to a low carbon economy, which was discussed at length during the aforementioned UN Climate change summit.
TAX INVERSIONS – IMPLICATIONS FOR COUNTRY CLASSIFICATION
Tax inversion refers to a company relocating its headquarters and incorporating in another country to attempt to lower the company’s tax obligation. Generally, the relocation has no material effect on the company’s operations. Several large mergers, including Burger King and Mylan, were announced that may trigger relocation and a tax inversion.. The U.S. government has changed some regulations to limit corporate tax inversions. The overall impact on index mandates depends on global classification methodologies for various index providers and whether a tax inversion will trigger a movement from a U.S. index to a non-U.S. index.
Recently, S&P Dow Jones Indexes announced that companies reincorporating outside of the United States will no longer be eligible for inclusion in the Dow Jones Industrial Average. While the Dow is often cited in the media, the overall size of the assets tied to the Dow is not likely to affect the underlying stock holdings. Larger indices, such as the S&P 500 and Russell 3000, employ more complicated methodologies to classify a company’s country. Historically, Russell indices used incorporation only to determine the home country of a company. In recent years, index providers used a global perspective, so the assignment of a company’s home country involves more variables. Russell uses incorporation, headquarters and the most-liquid exchange. When those items are not all the same, the secondary variables of revenues and assets are considered. While a company like Tyco may be incorporated in Switzerland, more than 50% of its reported revenues come from North America. Both S&P Dow Jones and Russell include Tyco in their respective U.S. indexes. Given these more-comprehensive factors, a merger classified as a tax inversion is unlikely to change the primary exchange of a stock, and the assets and revenues of the company are not going to be affected. So even though the tax inversion strategy has made news lately, for most index funds, the impact will be minimal.
ALIBABA – THE BIGGEST IPO IS MISSING FROM GLOBAL INDICES
With the Alibaba Group (BABA US) IPO pricing on September 18, the size of its capital raise has led to questions in the global equity investing community about whether the stock will be added to global benchmarks. Based on the corporate structure and the company’s decision to solely list in the United States, Alibaba will not be added to widely used global benchmarks from MSCI and FTSE in the near future.
When assessing a company’s eligibility for a benchmark, the first step is to determine the country assignment. When index providers determine a country assignment, they first look at country of incorporation and primary listing. Should these characteristics be the same and should that country be a member of the benchmark, the company is eligible for inclusion. Alibaba is incorporated in the Cayman Islands, and the company has decided to have a singular public listing on the New York Stock Exchange in the form of a depository receipt. Without uniformity, index providers then consider just the primary listing location and assess whether Alibaba could be assigned to that country.
Since Alibaba has decided it will not file Forms 10-K/10-Q with the Securities and Exchange Commission (SEC) and instead chose to file Form 20-F, it fails to qualify for U.S. classification, according to MSCI’s methodology. With respect to FTSE, the fact that the U.S. listing is in the form of depository receipts precludes it from receiving a U.S. assignment.
The next step for index providers will be to examine the additional factors such as location of operations, geographic sources of revenues, location of headquarters, management and shareholder base. The examination of these additional economic and geographic factors has led to Alibaba receiving a country assignment of China. Thus, with China as the country assignment and given the lack of an affiliated listing there, Alibaba is not expected to be added to any of the widely used benchmarks in the near future. Certainly, this could all change should Alibaba choose to change its country of incorporation, begin filing Forms 10-K/10-Q with the SEC or have a local (Hong Kong) listing.
1 Source: Northern Trust, MSCI. Data as of 6/2/2014.
2 Source: Northern Trust, MSCI, FactSet. Return data as of 5/31/2014.
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