Emerging Markets

Navigating institutional investor expectations : Tips for EM boards and executives

This is a guest post by Alissa Amico, Managing Director of GOVERN Center.

ESG (environment, social and governance) investing might well have emerged as the most fashionable acronym in the financial media in the past year. It encapsulates the growing expectations of the institutional investor community regarding the quality of corporate governance frameworks internationally, while demonstrating that investor expectations have in the meantime have also expanded beyond G(overnance).

With the growth of institutional investors - notably developed countries’ pension and insurance funds – these actors have become active not only domestically but also in emerging markets (EMs). Overall, of the almost 14 trillion USD of capital tracking MSCI indices, close to 2 trillion are now allocated specifically to Emerging Markets. In Turkey for instance, foreign institutional investors have until recently have accounted for half of the market capitalization.

This is significant for a number of reasons, including their influence on corporate governance. In many EMs, foreign investors are more active than domestic from a voting perspective since the latter’s participation in the capital market can be limited by law. Equally, many EM institutional investors lack the engagement culture and experience, despite having a better knowledge of the domestic market.

While developed market institutional investors are active in their own domestic markets, the extent of their participation in EMs varies depending on their risk appetite – Canadian institutional investors for instance tend to shy away more from EMs such as the Middle East than their American peers. Importantly, their participation is contingent on their perception of the quality of national ESG regulatory frameworks in individual emerging markets.

As such, Brazil has become a darling of foreign institutional investors due to the introduction a voluntary corporate governance listing segment (BOVESPA). While the success of BOVESPA has proven difficult to replicate, EM capital market regulators and stock exchanges have raised corporate governance requirements over the past decade, often at a faster pace than their developed market peers.

Both for EM regulators and companies this approach has delivered. On a macro-level, higher governance practices have proven to correlate with higher foreign inflows, as highlighted by the World Federation of Exchanges in its recent analysis of EM investing. Markets where a full set of well-established corporate governance requirements was in place received additional foreign inflows as high as USD 756 million over 2006-2018 period.

Indeed, foreign institutional investor participation in emerging markets is fundamentally linked to their appreciation of national corporate governance regimes, which generally include the governance code, listing requirements and any relevant provisions of the corporate law. It is likewise connected to their perception of the quality of oversight and enforcement which generally tends to be more problematic in EMs.

In many instances however, foreign institutional investors are not always aware of the extent of governance regulatory change that has taken place in EMs. Few investors are aware for example that listed companies in Oman are required to have a fully non-executive board. In part to make enforcement easier, the regulatory philosophy adopted by EM regulators tends to lean more on the side of mandatory regulations as opposed to UK-inspired “comply-or-explain” codes.  

Furthermore, foreign institutional investors’ understanding of strategy and governance of individual EM companies can be limited. Indeed, smaller companies not included in EM or large cap domestic indices often do not get any research coverage. Our earlier work in Egypt has demonstrated that only 10% of listed companies where followed by analysts whereas close to two-thirds of listed firms had no coverage whatsoever.

Indeed, collecting quality ESG data is frequently cited as the number one challenge by foreign institutional investors in different EM regions. They may not have access to annual reports in foreign languages or fully understand issuer disclosure, which in many cases remains not comparable due to the discrepancies in disclosure frameworks.

While the ESG data reported by EM companies remains patchy, expectations of its disclosure have high-rocketed in recent years. Encouraged by the recent stewardship trends worldwide, developed market institutional investors have introduced voting policies that reflect their specific investing philosophy.

In many cases – and this can indeed  be problematic – ESG priorities are not set in a country or region-specific manner. Blackrock, the largest institutional investor globally, has one voting policy for the entire Europe and Middle East region. Nonetheless, voting policies are an instructive read for boards and executives of EM companies wishing to differentiate themselves from the market based on the quality of their governance.

In particular, they may need to understand how foreign institutional investors’ stewardship and voting policies differ from national governance requirements. This can indeed be important especially for mid-cap companies that may not be automatically noticed by passive, index-tracking investors. In examining institutional investor voting policies, understanding their rationale and objectives is primordial.

For instance, in OECD member countries, having a majority independent board is a prevalent requirement whereas many EM regulators have shied away from imposing it as a standard. While EM company practices tend to mirror their domestic standard, expectations of foreign investors remain higher or different. In many instances, large institutional investors expect to have a largely or a majority independent board in listed companies.

Compliance of EM companies with foreign institutional investors’ ESG criteria matters and proxy firms voting their shares are instructed to do so with respect to these policies. For passive investors, lobbying for change may be conducted through a long-term engagement process. For active, stock-picking institutional investors, the approach may be more hands-on  since they often take risks in smaller, less known EM companies.

A key question then for EM firms is how to demonstrate their commitment to ESG in order to attract foreign institutional capital. Examining internationally recognised disclosure frameworks such as the IIRC to ensure the comparability of reported information is a critical first step. Too many annual reports of listed companies boast their philanthropic contributions and their positive environmental impact without any connection to company-specific risk factors, strategy or industry comparisons.

Some aspects of investor expectations may actually reflect priorities in their own markets and not necessarily those in EMs. This is perhaps most obvious when we consider the issue of executive remuneration. While executive and board remuneration has emerged as a major regulatory concern following the financial crisis, remuneration in EMs tends to be less of a concern.

As most EM companies are controlled either by the state or a family, board representatives who are often also major shareholders tend to be compensated by dividends, not sitting fees. In addition, board compensation in some EMs such as Saudi Arabia has been capped by law and hence remuneration does not represent a high risk.

The corollary of this for boards and management of EM firms wishing to attract foreign capital, is that they need to report on the information that institutional investors are seeking, even on issues that they may consider material or that are not required by domestic ESG regulations. The flexibility provided by the comply-or-explain (CoE) approach provides a possibility to address these criteria and concerns.

EM companies can use CoE not only as a mechanism for communicating to their own regulator and the local public, but also as a means of explaining to foreign investors why certain global governance standards may not be fully relevant. Explaining how a firm has gone above the national governance regulation can also be of benefit for all investors, as it demonstrates that the board does not take a minimalist, compliance – driven approach to governance.

Likewise, a demonstration by a firms’ reporting of how it has adapted its governance framework to the risks it faces geopolitically, financially and operationally is key. In doing so, EM firms can benefit from drawing a better connection between their strategy and their ESG practices. Boards and management need to stop considering ESG as E & S & G but instead as interconnected pillars of their corporate strategy.

The GOVERN Center works with boards and senior executives of leading EM companies to develop its governance practices in support of better financial performance and investment attraction. For more information: email: inquires@govern.center


Saudi Arabia: Long March Forward

This is a guest blog post by Dr Nasser Saidi. It originally appeared in CPI Financial

The Saudi Capital Market Authority, under new leadership, has announced that qualified foreign institutions will have access to the Tadawul stock exchange from 15 June 2015 with the final rules to be revealed on 4 May. This comes as no surprise, given the announcement in July 2014 of plans to allow direct foreign purchases of shares in the first half of 2015.

But why does opening up the Saudi equity market matter? What could be some of the macroeconomic effects? With Saudi and other oil exporters facing an oil price tsunami, economic policy should be directed at mitigating the negative consequences. The IMF estimates that there will be a massive loss of $380 billion in exports, equivalent to a 21 per cent hit to GDP. The expectation is that opening up the market will attract foreign capital that previously did not have access to Saudi investment opportunities. The capital inflow, in theory, could lead to increased investment in promising sectors, bring in new technology, boost IPOs, galvanise mergers & acquisitions and improve corporate governance all of which would translate into greater economic diversification and job creation, the overarching economic policy concern. The underlying risk is that asset prices get bid up, a bubble forms, Saudi investors sell and real invest does not happen.

LIBERALISATION AND OPENING UP

Opening of the market comes as part of a continuing policy of opening up, economic liberalisation and gradual international integration that has been pursued over the past 10 years. Saudi Arabia has been successful in upgrading infrastructure, strengthening education and skills, boosting access to finance for SMEs, and significantly improving the business environment. Substantial progress has been made on lowering the cost of doing business over the years. Saudi Arabia is today the only Middle East country and only OPEC member among the constituents of the G20. It joined the WTO in 2005 (which included clauses like allowing 60 per cent foreign ownership in banking and insurance, and 75 per cent foreign ownership of distribution within three years). Saudi built economic cities and industrial zones to move away from its over-dependence on oil. But oil still accounts for about 92 per cent of government revenues and though the share of non-oil real GDP has increased over the past two decades, non-oil sector exports remain limited. Foreign investment can support economic diversification.

SAUDI CAPITAL MARKET LIBERALISATION NEEDS ACCELERATION

The conservative Saudi capital market regulator had initiated several steps to liberalise the market over the last few years, including aligning working days with other GCC and international markets with Tadawul opening on Thursdays, and improving corporate governance standards to make the Saudi market attractive to foreign investors. Draft market access rules, shared in August 2014, included a 10 per cent cap on foreign ownership of the market’s value and that a single foreign investor could own no more than five per cent of any listed firm, while all foreign institutions combined could own no more than 20 per cent. If this limit is confirmed then the promised Saudi overture might prove to be too timid, a damp squib.

The Saudi and other GCC stock markets are massively dominated by retail investors. Retail investors currently account for more than 90 per cent of the share trading volume of the Tadawul, while foreign investors have been restricted to buying Saudi shares indirectly through swaps or exchange- traded funds. But retail investors may be prone to fickleness and bouts of irrational exuberance leading to volatility. Institutional investors such as pension funds, insurance companies, and investment funds are less likely to be prone to animal spirits, or so it is hoped. Increasing the share of institutional investors should help stabilise markets.

Opening of Saudi capital markets has been proceeding in phases, initially opening up to GCC investors, then opening to investment funds and now opening to qualified foreign investors.The opening up provides foreign investors access to the largest economy and

capital market in the Middle East. Saudi Arabia is the largest economy in the Middle East, with a nominal GDP of $752 billion in 2014. Tadawul has over 160 stocks, a market capitalisation of approximately $530billion and relatively more diversified compared to other exchanges in the region, with sector representation from petrochemicals, banking, telecom companies, retail and real estate. The chart below, shows the market capitalisation and turnover of the GCC markets, underscores the importance of the Saudi market: Tadawul alone accounts for more than 50 per cent of the market cap of the GCC countries and is the most liquid.

TADAWUL WILL MOVE FROM ‘FRONTIER’ TO ‘EMERGING’ MARKET STATUS

Saudi’s ouverture finally allows foreign investors to diversify risk and gain exposure to GCC investment opportunities through UAE, Qatar and now Saudi markets. Indeed, it is only in the past year (May 2014) that both UAE and Qatar were reclassified from Frontier to Emerging Market Status by the MSCI. MSCI considers both size and liquidity requirements and market accessibility for its country classification into Frontier or Emerging. The former are based on the minimum investability requirements while the latter are based on qualitative measurements that reflect international investors’ experience in investing in a given market, including laws, rules and regulations that provide for investor protection.

Will Saudi Arabia go through this process of a reclassification as well? According to MSCI, based purely on the existing size of the Saudi market, Saudi Arabia would have an equivalent weight of about 63 per cent in the MSCI Frontier Markets index, and about four per cent in MSCI Emerging Markets — the inclusion would attract passive foreign institutional investors or index investors that would have to rebalance their portfolios to include Saudi. The index house has already stated that a market does not necessarily need to pass through frontier status before entering the Emerging Markets universe. The earliest Saudi Arabia could officially enter either the frontier market or emerging market (more likely) would be mid-2017 considering the usual timelines for the evaluation and consultative process. Saudi Arabia, at present, has a standalone classification from S&P.

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FINANCIAL MARKET LIBERALISATION IS KEY TO ECONOMIC DIVERSIFICATION

What can Saudi Arabia look forward to with the opening up of its capital markets and subsequent foreign investment? Opening the stock market is only one step in what ought to be a Saudi financial markets development strategy. Efficient financial markets require breadth (a wide variety of financial securities and instruments), depth (sufficient size to enable transactions without leading to large bid-ask spreads) and liquidity (ability to enter and exit markets without affecting price).

Saudi needs active money markets, bond and Sukuk markets, and a mortgage market for housing finance. Saudi Arabia should however use the opening up of its capital markets to encourage more listings of both Saudi and GCC companies (dual listings). The exchange is largely dominated by energy-related companies and financial firms. It is necessary to reduce the high concentration of capitalisation in a limited number of stocks: for example, the top FIVE names (including SABIC and Al Rajhi Bank) account for more than one-third of Tadawul. Developing the financial markets should also be part of a strategy of economic diversification, via attracting capital into promising sectors such as tourism and hospitality, transport, education, health, services etc. but the time is also opportune to start a programme of privatisation e.g. Saudi Airlines and greater PPP in infrastructure and logistics.

OPENING TADAWUL SHOULD BE PART OF A ‘LONG MARCH FORWARD

The ouverture of Tadawul should be part of the equivalent of a Chinese ‘Long March Forward’ of a continuing modernisation and reform strategy and of greater regional and international economic integration. The move should be a harbinger of further reform providing wider market access and establishment of foreign companies and persons via deep legal and regulatory reforms,public private partnerships,and privatisation and labour market reforms to create a dynamic,vibrant economy able to create jobs for generations of young Saudis, both women and men. But why stop there?

As the region’s biggest economy, Saudi can and should be the region’s engine of growth. Given Saudi’s massive wealth and being a major capital exporter, the Saudi market should be open to foreign listings (including government and corporate bonds and Sukuk) and cross-listing from the other GCC and Arab markets. An example would be allowing Egyptian companies and government to list equity, bonds and Sukuk that would help finance Egypt’s infrastructure, inclusive economic growth and development. Finance and trade are better than aid! Saudi’s Tadawul should move away from being insular and inward–looking to become a regional market helping finance economic growth and development across the Arab world and wider region.



Is Tehran Stock Exchange Index truly representing the overall market behaviour?

This is a common question asked multiple times by market practitioners and observers of Iran’s capital market. This is essentially due to the asymmetry readily witnessed by those who buy and sell stocks of companies listed on Tehran Stock Exchange (TSE).

Indeed, there are occasions when mixed signals are communicated by the All-Share Index if you happen to make professional investment decisions based on interpretations of the benchmark index.

For instance, you might see in one typical session of the exchange market that the gauge is in the red zone by about 300 or 400 points down but there are many sectors across different market boards that are experiencing gains rather than losses in price in spite of the general negative environment usually seen under such circumstances.

In one recent study performed by Armin Sadeghi Adl, Tehran Stock Exchange Company’s expert at Research Management Division, he underlined the fact that there is a meaningful diversion between two major indexes used to quantify the general behavior of the equity market namely, value weighted index — being constantly blamed for its shortcomings to illustrate the true performance of the market — and equal-weighted index, which was introduced just two years ago to the market activists and researchers.

As Mr. Adl explains about his research in his article, published by the well-reputed economic Daily, Donya-e-Eqtesad, he assures us that value-weighted Index or locally known as Overall Index does not genuinely illustrate the reality of the market since this measure is initially composed of weight of firms based on their market cap size, which is very misleading. This is because of the calculation measures employed to specify the influential companies on the Index.

In In fact, the number of listed companies allowed to be included in this computation does not exceed 17 from 321 ones present in TSE. Additionally, their market cap goes beyond 50% which is in stark contrast to the 10%, belonging to just 231 companies.

Thus, this is to say that TSE Index is impacted by small fraction of giant names. Consequently this is not a guiding element to those who adjust their investment decisions and strategies solely by such an indicator, according to Mr. Adl.

In the same vein, the equal-weighted index was introduced in 2014/15. From the time this measure first used till the first two months of current Persian Calendar, it showed a solid 33.5% growth.

Meanwhile the Overall Index registered 8.1% dip. In other words, unlike the down cycle perceived in the market throughout the period, there existed lucrative opportunities for those individuals to forego the false signals emitted by the Index and achieve acceptable and at times unexpected returns.

Statistically speaking, in the first quarter of the current Iranian year, while the Index went down by about 9.5% and the average return resulted by 17 big cap companies dropped by 10.2% (with a market cap of above 50%), there were 131 firms in the exchange market with positive returns.

It is noteworthy to say that small cap entities recorded 21% of stock trades in the same period which is a telling testimony to the claim that the market participants were ignorant of many other names in the market.

It is also good to know that many of the giants in the capital market of Iran are notoriously labeled as “index builder” as they they are the driving forces behind market downs or ups.

To shed more light on the matter, let’s take the largest and smallest names present in TSE as an example for the sale of clarity.

Persian Gulf Petrochemical Company which enjoys 8.4% share of total market cap and Tehran Derakhshan Company with a meager 0.003% stake of the whole market are the largest and smallest companies in Tehran Exchange Market. As it is self-revealing, we can understand the big difference a factor such as market cap can exert on Overall Index swings.

This is why someone who is interested in investing in the exchange market of Iran should not allow themselves to get misled by following Index movements in either directions. Rather, interested individuals should enter the market with open eyes and ample knowledge of the dynamics and fundamentals of the market.

Moreover, when studying the first quarter performance of the TSE, what actually surfaces is that most investors were unluckily focused on surprisingly just 16 names out of 321 ones available for investment in the market, according the research finds by Mr. Adl. It was so much so that half of the value of trades were single-handedly won by the big names across the market.

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Moreover, turnover ratio for most traded shares has a lot to tell us. According to Mr. Adl, half of these firms experienced more than 100% turnover ratio. In other words, their shares had changed hands at least once in the market during the period.

As a live example, we can name Saipa Investment Company, with minus 9.8% return in the period. This company had the highest share turnover ratio among the list of 16 companies most favored by the market participants. Nevertheless, the average for this ratio was 99% among big cap firms in the equity market.

Nonetheless, the aforementioned companies’ loss ranged from minus 3.3% to minus 43.9%. The average was minus 23.5% in the period, however.

All in all, it appears that although the Tehran Stock Exchange did not pass upbeat trading sessions on the whole in the last quarter, it is evident that there are big opportunities out there. Therefore, it is the investors themselves and not just the investment environment to point the finger of blame at for the low or negative returns realized.

This is a guest post written by Navid Kahlor, Freelance Contributor at Al-Monitor. The original can be found here.

MSCI says no to China

Last night, MSCI, the world’s largest indexing firm, announced that it will not be adding China’s A shares as constituents of its widely followed EM index.

It has also made a number of comments which were of interest to global emerging funds following Pakistan, Nigeria, Argentina and Saudi Arabia.

In summary:

1. For passive EM funds, the MSCI EM index is the most significant globally by far, with around $1.5 trillion of indexed investment. For active investors, any change in the weighting of the index (which they are benchmarked against) forces them to reassess the composition of their portfolios.

2. MSCI pointed to a number reasons behind their decision regarding China’s A share market, the main one perhaps being capital mobility. First and foremost, the monthly repatriation limit (the amount of his total capital the investor is able to withdraw from the market during one month) of 20% is considered too low, especially should the fund be faced with redemptions. The time-consuming and opaque process of receiving approval for a quota (allowing investors to invest in Chinese stocks) is also a factor. On top of this, the need for preapproval of financial products on foreign stock exchanges that are linked to A-share indices has not been yet addressed.

It is important to note that China is already the largest component of the MSCI EM Index, making up over 25% of the index. This is made of up of ADRs of Chinese companies listed in NY or Chinese shares quoted in Hong Kong. The domestic (A-share) stock market — the largest in the world after US — is not included in the index.

3. MSCI announced that Pakistan will be reclassified as an Emerging Market. Given its current account deficit and need for capital to drive steady growth, many observers agreed that Pakistan was the biggest winner from yesterday’s announcement.

4. Argentina will be reviewed for a potential upgrade. In December 2015, the Argentinian Central Bank abolished foreign exchange restrictions and significantly relaxed the capital controls that have been in place for a number of years. These changes have resulted in a floating currency, the elimination of cash reserves and monthly repatriation limits on the equity market, as well as a significant reduction in the capital lock-up period for investments.

5. Nigeria may be removed from MSCI’s Frontier Markets Index and reclassified as a stand-alone market due to capital mobility issues. This may even come as soon as November this year. Early last year its Central Bank pegged the local currency to the US dollar resulting in a sharp decline in liquidity on the foreign exchange market. Hence, the ability of international institutional investors to repatriate capital has been significantly impaired to the point where the investability of the Nigerian equity market is being questioned.

6. MSCI said that it welcomes the recent market enhancements announced in Saudi Arabia, which opened its market for the first time to foreign investors last summer. These include changes to the rules for qualified foreign investors, settlement cycle of listed securities, elimination of the cash prefunding requirement and the introduction of proper delivery versus payment. Many of these are on course to be implemented by mid-2017 and will bring the Saudi equity market closer to EM standards.

Sources: MSCI, FT, Natixis

Technology’s potential to ‘emerge’ markets

Earlier this year, one of the largest remaining ‘closed’ emerging markets, Iran, followed Saudi Arabia in opening up its stock market to foreign investors as financial sanctions were officially lifted following last year’s breakthrough nuclear deal between Iran, the US and other world powers.

Emerging and frontier market fund managers are now looking closely at Iran to evaluate its investment potential, as shown by the rapidly growing number of Iran-focused funds as well as the increase in investor travel to Tehran during the last six months. The Tehran Stock Exchange already has a large, diversified and liquid stock market with more than 400 listed companies and a market capitalization of around $90bn. On top of this, the country’s IPO pipeline is potentially as large as $100bn, an enticing prospect for international investors looking for growth opportunities.

Before they are able to invest substantially in Iran, investors must first satisfy internal compliance teams by getting to grips with a market where investor relations and corporate governance standards still have a lot of catching up to do. This is usually a long and fairly painful process as investors, companies and regulators move at different speeds, speak different languages and follow different practices.

Technology could play a vital role in helping companies in countries who are entering the global capital markets arena for the first time, such as Iran and Saudi Arabia, to integrate and engage with the international investment community. It’s probably fair to say that the success of technological innovation in this area will be based largely on its ability to help companies to level the playing field between global investors and local investors.

The investor relations community has been slow to embrace innovations which are already revolutionising other industries. A Google Street View of the Emirates Airbus A380 for example gives travellers a full virtual product tour of the plane from their desks. Bernie Sanders used the 360 interactive video to great effect at his rally in the run-up to the Iowa caucus.

For most fund managers, there is no substitute for a face-to-face meeting or a company site visit, during which they can see the whites of management’s eyes and walk around the corridors of the company’s headquarters. But as global portfolios become more and more diversified, technology could help investors to cover more ground by increasing the effectiveness of ‘remote’ engagement at a fraction of the cost. Forward-thinking IR teams could adapt 360 technology to enable analysts and investors to interact not only with company premises, but also with senior executives and product managers. In a few years, the Oculus Rift headset could take this idea a step further to provide an even more immersive experience.

Simple smartphone applications allow ordinary consumers to order taxis, find dates, book flights, order takeaways and operate their central heating from the office. They allow warehouse managers to control stock and doctors to monitor patients’ blood pressure. At the same time, IROs and fund managers still rely heavily on emails, phone calls and business trips to conduct most of their daily tasks, which require time, money and organisation. In this environment, it is perhaps unsurprising that the process of building knowledge, trust and confidence in a company or market takes as long as it does.

For innovation to be embraced, it must make the fund manager’s job more efficient without forcing him to surrender his competitive edge or limiting his access to the company in any way. It must help the IRO to tell the company story more efficiently and to a wider audience. The opportunity for such a solution is perhaps greatest in emerging and frontier markets given the lack of existing IR infrastructure and desire for short-term international growth. Despite still being relatively undeveloped from a global capital markets point of view, countries such as Iran, China and Indonesia boast increasingly tech-sophisticated consumer markets, which perhaps bodes well for their respective corporate counterparts.

Technology innovations could offer open-minded IR teams in emerging and frontier markets a unique chance to quickly close the gap between them and their richer, more experienced developed market rivals. The lack of an existing process for engaging with international investors may even give them an advantage over established companies reluctant to think outside the box and adapt.

This article first appeared in the spring edition of UK IR Society’s magazine ‘Informed’.

Saudi Arabia to Open its Equity Market to Direct Foreign Investment

After a number of years in the making, the Saudi Arabia authorities finally announced last week that Qualified Foreign Institutions (QFIs) will be allowed to invest in shares listed on the Tadawul starting from June 15th, 2015. While foreign investors have been able to invest in Saudi Arabia since 2008, this has been limited to ETFs, swaps and P-notes, none of which allow direct ownership of the underlying equity. Opening the market to QFIs as a first step is a tried and tested approach in emerging markets (e.g. China in 2002, India in 1992, Taiwan in 1991). Institutional investors who do not meet the criteria for investing directly will likely continue to use the existing products mentioned above.

The Tadawul is the Middle East’s largest and most liquid market, and effectively the largest closed emerging market today. The 165+ listed companies have a combined market capitalisation of over $550bn, with petrochemicals and financials industries the dominant sectors. Recent IPOs have added more consumer and non-cyclicals to the market. A number of commentators are speculating that Saudi Arabia could receive an emerging market classification from index provider MSCI within the next two years, which is in turn likely to drive additional investor interest. MSCI’s Sebastien Lieblich was quoted last year as saying that if Saudi Arabia were added to the Emerging Markets Index it would constitute around 4 per cent of the total market, similar to Mexico and Russia. This development would mean that Saudi Arabia could make it into the top 10 rank of EMs as classified by the MSCI (see graph below).

The Kingdom presents investors with a unique set of dynamics. Its economy has gone from strength to strength in recent years as it has benefited from high oil prices and output, strong private sector activity, increased government spending, and the implementation of a number of domestic reform initiatives. Rising oil prices and oil production have also resulted in large external and fiscal surpluses, and government debt has declined to almost zero. With a population of over 30 million, over half of whom are under 25 years old, it is the region’s youngest and most populous nation. Of course, there are risks. First, the Kingdom’s dependence on oil revenue (over 90 percent of fiscal revenues and 80 percent of export revenues come from the sale of oil) leaves it hostage to fluctuating oil prices, as have been seen since the summer of 2014. Geopolitical tensions in the region further added to such worries. As with all emerging markets, there have been some corporate governance-shaped bumps in the road, however the opening of the market to foreign investors will undoubtedly help smooth the path to transparency and benefit companies and investors alike.

Sources: International Monetary Fund, Bloomberg, Morgan Stanley, MSCI

How to define Emerging Markets — Prof. Andrew Karolyi

A couple of weeks ago we were invited by BNY Mellon Depositary Receipts team to attend an interesting talk by Andrew Karolyi, Professor of Finance at Cornell University, who published a book last month entitled “Cracking the Emerging Markets Enigma”.

The book is intended to address the ongoing confusion around how we define emerging markets. Professor Karolyi stresses that much of the misunderstanding stems from an obsession with ‘growth’: a universal, ‘efficient’ model (which he proposes here) should take into account all relevant factors and provide a standardised evaluation of any market.

Professor Karolyi identifies six key areas which help us to classify individual markets both quantitatively and qualitatively:

1. Market capacity constraints (e.g. market cap to GDP ratio, bond market capitalisation)

2. Operational inefficiencies (e.g. commissions, taxes and costs, settlement cycles)

3. Foreign investability restrictions

4. Corporate opacity (e.g. governance and accounting standards)

5. Limits on legal protections (e.g. insider trading laws, self-dealing, directors’ rights)

6. Political instability

He then applies this six-pronged formula to 33 separate emerging markets, using regression analysis to assess the impact of each factor on foreign investment.

One of Professor Karolyi’s main frustrations is the need of the financial media to shoehorn all passing market trends into fixed, acronym-sized boxes. The most obvious example is the BRIC label, which may have made sense when it was coined by former Goldman Sachs economist Jim O’Neill in 2001, but has since lost all meaning given the wildly divergent paths of Brazil, Russia, India and China in the intervening years. A quick glance at the spiderweb diagrams below illustrate this point well:

To put this in context:

Professor Karolyi agrees that there are additional factors he does not take into account that fit somewhere into the six classification categories (e.g. freedom of the press, demography), but thinks the rating system provides a picture of each market which is as accurate, comprehensive and balanced as possible. He also accepts that there are a number of so-called ‘frontier’ markets for which there are simply not enough data to build an accurate model. This in itself tells a story about the quality of governance in these markets.

One of the research’s key findings is that only five out of 33 emerging markets (Israel, South Korea, Peru, South Africa and Taiwan) were overly favoured by global investors in 2012 relative to their respective weights in the MSCI ACWI (see chart below). The majority were proportionally underweight with Russia, India and China in particular standing out, the latter largely as a result of foreign investment restrictions.

Between 2012 and 2013, despite clear net outflows across the EM space (many of which have since been reversed), individual markets again defied prediction or pattern, further underlining the pitfalls of lumping such diverse and volatile markets together under an all-encompassing ‘emerging markets’ banner.

In order to get to the bottom of this apparent unpredictability, Professor Karolyi uses regression analysis to identify the main factors driving increased or reduced investment from amongst the six categories. The results, which are discussed in detail in the book, should be an eye-opener for companies in these markets, particularly those with a relaxed attitude towards corporate governance.

The search for a universal model, one which eschews labels and classifications and relies instead on standardised empirical data which tell a full and visual story (particularly in the murky world of emerging markets), should be commended. An HSBC advert currently doing the rounds reads “In the future, there will be no markets left waiting to emerge”. Until that happens, Professor Karolyi’s model provides a useful roadmap to growth and investability for emerging economies and a comprehensive checklist for investors looking across a number of increasingly diverse markets.

China’s place in the Emerging Market Club

Last week saw the resolution of a long-running saga in the emerging markets investment community: the inclusion of China’s restricted main market ‘A-shares’ in the MSCI Emerging Markets index.

The decision was watched very carefully by active and passive investors alike. For passive EM funds, the MSCI EM index is the most significant globally by far, with around $1.7 trillion of indexed investment. For active investors, any change in the weighting of the index (which they are benchmarked against) forces them to reassess the composition of their portfolios. After the recent 12-month rally, China’s equity market (which is worth around $10 trillion) is now the second largest in the world after the US.

Although China’s A-share remains on course to be accepted onto the EM index, the MSCI is holding off for the time being. The index provider says it needs assurance from authorities that foreign investment quotas are transparent and predictable, and also that there is enough liquidity, capital mobility as well as a defined account ownership structure in its new StockConnect programme.

MSCI will revisit the topic in May 2017; the focus for now is on how investors plan to allocate assets to China as part of the broader market opening.

A recent FT piece made an interesting point — if all A-shares were to be included at their full weighting, China would take up 43.6 per cent of the emerging markets index. This is a good illustration of China’s importance to the emerging world, although there are profound practical implications for fund managers looking for diversified exposure to global EMs.

Speculation in the press is already mounting over the likely emergence of a spate of “EM ex-China” funds.

BlackRock launches its first China A share ETF for international investors

As China is opening its stock market to greater foreign investment, licensed fund managers are using their own Renminbi Qualified Foreign Institutional Investor (RQFII) quota to offer new products to their clients. BlackRock has today launched an ETF focused on the hard-to-access A shares in China, that aims to track the performance of the MSCI China A International Index. This index represents a broad and diversified basket of over 300 large and mid cap stocks.

The fund is listed on the London Stock Exchange, giving BlackRock’s international institutional and retail clients direct access to China’s A share equity market. A shares are mainland China incorporated companies listed on the Shanghai and Shenzhen Stock Exchanges. China A shares represents about 45.6% of the Chinese equity market, as defined by the MSCI China All Shares Index, which contains A shares, B shares, H shares, red chips and private chips.

Further References:

Fund Fact Sheets

Fund Prospectus