After MSCI’s questionable upgrade for Argentina and Saudi Arabia, do its powers need to be downgraded?
Nicholas Spiro says that following MSCI’s delayed inclusion of China, granting emerging market status to Saudi Arabia and Argentina may leave many wondering whether it, and other providers, are the best guides to investment opportunity
Yet, it is not the first time the decisions and influence of MSCI have come under scrutiny.
A significant portion of this money is parked in “passive” funds, cheaper investment vehicles which, unlike their actively managed counterparts, simply track one of the main indices. Even active funds have been accused of misleading investors by closely following their benchmark, a practice known as “closet tracking”.
MSCI is particularly influential because it compiles the dominant emerging markets equity index, followed by some US$1.6 trillion in assets. This puts MSCI, and the big fund managers that are its main clients, in a powerful position to determine the volume and direction of capital flows to economies that account for nearly 60 per cent of global GDP since it has the final say on which stocks and countries go into its indices.
MSCI’s decisions, moreover, notably its reasons for classifying economies as emerging or developed, are subjective and controversial, casting doubt on whether an index-maker should wield such influence.
While MSCI had legitimate reasons for not acting sooner, given persistent concerns about the opacity of China’s markets and Beijing’s heavy-handed interventions in 2015, the 234 A-shares that are finally being added to its index this year will have an overall weighting of less than 1 per cent due to the inclusion of just 5 per cent of the stocks’ respective market caps.
Watch: China’s growing wealth
Still, MSCI is by no means alone in inviting criticism.
All the large index providers are accused of failing to capture significant changes in global GDP and the structure of fixed-income and equity markets. The major bond indices, compiled by Bloomberg and Citigroup, only assign a 2 to 3 per cent weight to emerging markets, even though they now account for a fifth of the world’s outstanding bonds, according to Ashmore, another big asset manager.
This is because advanced economies issue much more debt than developing nations, forcing investors who track the indices to be most exposed to the most indebted borrowers, irrespective of their creditworthiness or performance.
The majority of the big equity indices, meanwhile, are weighted according to market cap. So, if the price of a company’s shares increases, index-trackers are obliged to purchase more of it, increasing the risk of asset bubbles.
Still, index providers are not entirely to blame. Their power is enhanced by the phenomenal growth of index-based passive investing, in particular popular exchange traded funds whose assets have reached almost US$5 trillion, according to ETFGI, a London-based consultancy.
MSCI’s decisions may be controversial, but the fact remains that it has amassed an army of index-tracking followers.
Nicholas Spiro is a partner at Lauressa Advisory