When things get messy (MSCI)

09 May 2019

By Ronan Kearney,

Responsible for Fund Structure & Governance on the Verbatim Investment Committee

For intermediaries only

In the fourth of a series of five articles, Ronan Kearney Responsible for Fund Structure and Governance on the Verbatim Investment Committee, examines emerging markets investment assumptions that many professional fund managers and advisers take for granted. He raises the questions: Are these investment assumptions justified? Or are there potentially alternative approaches to asset allocation and portfolio construction that could better serve the financial community?

Emerging Market equity can sometimes be treated as a bit of an afterthought by asset allocators and general multi-asset managers, as the risk and return profile means that most investment models only allocate between 3% and 7% for the most popular ‘mid-risk’ portfolios. However, for more adventurous portfolios, scoring for example a risk profile 7 or higher in popular rating systems, this allocation can be as high as 30%. As such, it is imperative that advisers understand what ‘emerging markets’ actually means in terms of country and industry sector exposure.

When ETF managers select an index provider for their products, they typically go for big brands, in particular they tend to select MSCI. If we look at the developed world category, the MSCI World index utterly dominates the field: with 17 MSCI World ETFs (as of December 2018) compared to a single FTSE Developed World ETF (not including factor or sector tilts). The story continues in Emerging Markets, where MSCI dominates the investment product space: 12 to 1 vs FTSE for emerging market investment products. 

It’s only by detailed analysis of the regions and sectors that other index providers such as FTSE use for their construction, that you can see how the variance can play a significant role. Despite MSCI’s global dominance, on the face of it, there is little obvious difference between their offering and FTSE’s: both offer broadly diversified, market capitalisation-weighted indices. But as usual the devil is in the detail and when you do a full analysis some quite deep differences start to emerge.

Country Weightings (as at 23.04.19):





The biggest and obvious difference highlighted in the above graph is South Korea. Given that South Korea is the 12th largest global economy in April 2019 according to the IMF (it's ranked 14th by stock market capitalization as well), has a stable political system, and well developed capital markets,  it seems odd to consider it as an emerging market, to do so feels a bit ‘1980’s’. South Korea's economy is larger than both Spain and Australia, which are both considered developed markets, and 3 times larger than Sweden. It’s quite likely that if investors have global developed market investments in their portfolio, they already have global firms such as Samsung and Hyundai, so adding in extra South Korean exposure arguably defeats the objective of achieving risk diversification by investing in emerging markets. In this case, the FTSE benchmark arguably serves your purposes better.

Market Capitalisation

The definition of what constitutes a small cap company is another material difference between the index methodologies. MSCI indices include 85% of the investable universe by market cap and exclude the bottom 15% as small-cap firms. But FTSE indices track 90% of market capitalisation and only exclude the bottom 10% as small-cap firms. The outcome is that FTSE includes some companies that MSCI define as small cap. This has a knock-on effect in terms of sector exposure as detailed below:

Sector Weightings (as at 23.04.19):








Combining the country exposure to the market cap and industry sector exposures does seem to indicate that the FTSE emerging market index does a better job of providing diversification to investment portfolios. But of course there remains the question of underlying index performance to consider as well. In reality, the performance characteristics are quite similar, but over time the FTSE does have the edge, having delivered 162.67% growth over the last 5 years, compared to 159.84% for the MSCI equivalent. On balance therefore, considering diversification, risk and performance, a strong case can be made for the FTSE EM Index as the preferred benchmark, which does beg the question as to why most asset allocators continue to use the MSCI?

Graph of FTSE vs MSCI e/m









Source: Morningstar

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