How do you classify an emerging market?
While the concept of an emerging market is well accepted, the way it is defined has seen different definitions and approaches by various institutions.
Stephen H. Dover, Chief Investment Officer of Templeton Emerging Markets at Franklin Templeton Investments, expressed his thoughts on the issue. He stated that, “what constitutes an emerging market has also changed significantly over time, but the waters in emerging markets have not always been very clear.”
A few examples
Dover holds that the classification of a country as an emerging market assumes importance because the categorization of a market and its weight in an index determines how many investors position their portfolios. Dover reminds that “we have seen countries shift in and out of emerging-market status over time.”
For example, in 2013 MSCI demoted Greece (GREK) from the status of a developed market to that of an emerging market. Meanwhile, the firm also announced last year that Pakistan will be promoted to emerging market status in its May 2017 semi-annual review.
FTSE, another major institution which classifies countries, had promoted Greece from ‘Advanced Emerging’ to ‘Developed’ in Jan 2001, but was then demoted back to the previous category in March 2016. Meanwhile, Argentina was demoted from ‘Secondary Emerging’ status to ‘Frontier’ in September 2010 and was further demoted to ‘Unclassified’ in June 2015.
At present, though both MSCI and FTSE classify 23 countries as emerging, the former considers South Korea (EWY) to be an emerging market while the latter classifies it as a developed market. Also, while Pakistan is yet to be included in the MSCI Emerging Markets Index, it is already classified as an emerging market by FTSE. Further, FTSE has sub-divisions for emerging markets, with 11 of the 23 being classified as ‘Advanced Emerging’ and the remaining defined as ‘Secondary Emerging.’
Impact on investment
Since several passively managed mutual funds and exchange-traded funds are benchmarked to indices provided by the aforementioned providers, a reclassification to and from the category decides the exposure an investor will have to these markets.
While the Vanguard FTSE Emerging Markets ETF (VWO) is benchmarked to the FTSE Emerging Markets All Cap China A Inclusion Index, the iShares MSCI Emerging Markets ETF (EEM) is benchmarked to the MSCI Emerging Markets Index.
Dover elaborates his point by explaining how the Templeton Emerging Markets Group selects its emerging market investments. Let’s look at that in the next article.