• A series of comparisons between the normative (MSCI Emerging Markets Index) and a positive emerging market (EM) benchmark shows significant differences across country, capitalization, and industry exposures.
• One implication is that investors who access emerging markets by benchmarking the MSCI EM Index are under-investing in China and small-cap constituents, while gaining outsized exposure to companies in the Communication Services and Information Technology sectors.
• Because capitalization-based indices are inherently backward-looking, countries and industries that represent the next leg of the developing world’s emergence are likely to be under-represented in the MSCI EM Index.

In Part I of A Tale of Two Indices, we introduced the concepts of normative and positive approaches to index investing. To quickly summarize: unlike a notional “positive benchmark” (a portfolio that aims to comprehensively represent the entire market’s capitalization), a “normative index” filters for companies along subjectively-determined criteria. Most index products are based on normative indices. The leading EM index, the MSCI Emerging Markets Index, filters in pursuit of its design for “a strong emphasis on investability and replicability of the indexes.”¹

The goal of Part II is to pick up from where Part 1 left off and provide concrete comparisons of the two approaches along critical investment facets: country and sector exposure, capitalization distribution, and individual security weightings.

This matters because of the pervasive influence that normative indices maintain in markets today, propelled by the mass commercialization of index-based investment products such as exchange-traded funds (ETFs). Bloomberg Markets argues in a November 2017 article, “In a market increasingly characterized by passive investing, these players can direct billions of dollars of investment flows by reclassifying a single country or company, effectively redrawing the borders of markets, shaping the norms of what’s considered acceptable in international finance…”² Figure 1 compares two commonly used normative indices with a positive EM benchmark, assembled by Seafarer; examining the differences helps illuminate how a normative approach can reshape investment exposures for passive products.³

Significant differences shown in Figure 1 suggest that MSCI’s index security selection features skewed sampling methods. It may be helpful to think of an index as like a statistical sample set: a subset of the whole that is designed to retain the population’s most important characteristics. If the sample is constructed in a way that distorts the representation – perhaps failing to capture certain facets or exaggerating the importance of others – then the sample selection process is said to be “biased.” For equity indices, a sampling that is an unbiased representation of the broader EM universe should produce an index with similar market exposures.

As there is no strictly positive index available in the market, we assembled a positive EM benchmark as the collection of all issuers with a market capitalization of at least 100 million USD-equivalent, domiciled across 26 EM countries.⁴ Unfortunately, it is not possible to avoid employing subjective judgment in defining the geographical boundaries of the developing world. The two leading index providers – FTSE Russell and MSCI – disagree on the development classifications for South Korea, Kuwait, and Poland, demonstrating that an “emerging market” cannot be simplistically categorized by wealth levels. In order to avoid this debate here, and to facilitate comparison, we default to MSCI’s EM country list of 26 nations for our positive benchmark.⁵

As illustrated in Figures 3 through 8, the data as of December 31, 2019 indicates substantial selection bias in the flagship MSCI EM Index. Note that while we use the MSCI EM Index for comparisons through the remainder of this paper, the situation is not unique to one benchmark, and we should expect other commercial indices to have their own distinct biases. For instance, MSCI’s all capitalization emerging markets benchmark, the MSCI Emerging Markets Investable Market Index (IMI) (included in Figure 1), was launched by MSCI in mid-2007 to provide an index with an inclusive capitalization mandate. Despite more than doubling the count of companies after adding small capitalization companies, the MSCI EM IMI added only 2.6% of market capitalization relative to the positive benchmark.

At a high level, the findings show an index that emphasizes some equities over others. Among a few of the favored sets: certain large-capitalization companies; companies listed in South Africa, Taiwan, South Korea; and those operating within the Communication Services, Information Technology, and Consumer Discretionary segments. Since index weights must sum to 100%, the corollary is that other segments are negatively weighted in the MSCI EM Index. These include small- and mid-cap companies, stocks listed in China and Hong Kong, as well as Industrials, Real Estate, and Health Care companies.

Country Exposure

Using Figure 3 to compare country composition in the MSCI EM Index to the positive EM benchmark reveals that the largest divergence is in the combined China-Hong Kong category. Specifically, the MSCI Index’s total weighting in China and Hong Kong of 34% is meaningfully below the 43% weighting in the positive benchmark. This discrepancy reflects MSCI’s incremental approach to the inclusion of Chinese A-shares.

In the positive EM benchmark, A-shares made up more than 3,600 constituents and 6 trillion USD-equivalent of market capitalization as of December 31, 2019 – representing roughly 23% of total EM capitalization. This compares to a 4% weighting in the MSCI EM Index, which while up significantly from the sub-1% weighting in 2018, still lags an objective weighting. Presently, the MSCI EM Index includes some 467 Chinese A-shares weighted at 20% of estimated free float.

Sources: Bloomberg, MSCI, Seafarer.

One related effect from this substantial under-allocation to China and Hong Kong is that several other smaller countries receive index allocations higher than a positive approach would entail. Figure 3 demonstrates that apart from China, Saudi Arabia is the only top 10 country that is “underweight” relative to the positive benchmark following Saudi Aramco’s December 2019 Initial Public Offering (IPO), as Aramco’s size is not well represented by the MSCI EM Index’s weightings. Meanwhile, South Africa has an outsized weighting in large part because of the MSCI EM Index’s high weighting in Naspers. Finally, South Korea and Taiwan’s weightings, each over 100% over their positive benchmark weighting, call to mind a common criticism of indices being inherently backward-looking; the MSCI EM Index’s over-weights in these relatively developed countries with their semiconductor leaders also leads to less weighting in markets and industries that are still in their emergence.

Capitalization Comparison

Both the MSCI EM Index and MSCI EM IMI are heavily weighted toward large capitalization company names, namely top 10 constituents including Alibaba, Tencent, Naspers, TSMC, and Samsung Electronics. Figure 4 contrasts the market capitalization distribution of the flagship MSCI EM Index with that of the positive EM benchmark.

Sources: MSCI, Seafarer.

It should come as no surprise that weighted capitalization is significantly higher for the MSCI EM Index. As of December 31, 2019, more than 80% of MSCI EM Index constituents had a market cap in excess of 3 billion USD-equivalent, compared to just 14% of constituents within the positive benchmark. The summary statistics tell a similar story: the MSCI EM Index has a median capitalization of 6.1 billion USD-equivalent; in contrast, the positive benchmark has a median capitalization of just 524 million USD-equivalent. Considerable gaps between the averages and medians reflect capitalization distribution in the EM, which has a long tail of smaller companies all but missing from the largest commercial indices.

What does this imply for passive investors? The MSCI EM Index’s mid- and large-cap scope, while serving as a filter for “investability and replicability,” also introduces a systematic underweight to small-caps. Investors may choose a passive product under the assumption that it offers an unbiased representation of the structure of the emerging markets; yet one prevalent index excludes some 70% of smaller EM constituents. Perhaps the most important way this subjective filtering affects investor portfolios is in industry exposures.

Capitalization and Industry Exposures

Figure 5 details industry weighting by company capitalization size of the positive EM benchmark. Small-cap stocks are markedly under-represented in certain sectors (indicated with red labels: Energy, Communication Services, and Financials), but enjoy strong representation in other sectors (with green labels: Consumer Discretionary, Health Care, Industrials, and Materials). Below this, Figure 6 compares the differences in capitalization representation at the industry level between the two benchmarks.

Sources: MSCI, Bloomberg, Seafarer.

Intuitively, these are three industries where scale matters. Telecommunication carriers (under Communication Services) are one example: for companies like AT&T and Verizon, size enhances a company’s ability to secure debt and fund investments in the latest network equipment, which can then attract more customers with the promise of smoother network coverage. Later, a larger paying customer base enhances the company’s ability to invest in the next round of spectrum upgrades, and the company gradually pulls market share from less well-capitalized competitors. After multiple rounds of investment, a new entrant’s odds of success are substantially diminished. In general, regulatory barriers and the requirement for billions in capital investments can cause an industry to skew toward large companies.

On the other hand, small-cap companies are well-represented within the Consumer Discretionary, Health Care, Industrials, and Materials categories (indicated with the color green). These sectors are less scale-driven and in many cases less regulated; companies may compete on factors that are unrelated to scale, such as marketing innovation, service standards and customization, or distribution and customer outreach. In the absence of regulatory hurdles or the need for legacy operations, these markets can also remain open to new entrants. Using cosmetics as an example (categorized within the “Consumer Discretionary” sector), a company with a compelling product can develop a brand and customer following, and with luck, publicly list within a few years. However, after its listing, there are few barriers to competitive entry facing new entrants, and the cycle of robust competition continues.

Figure 7 illustrates how capitalization size cut-offs in the design of the MSCI EM Index disproportionately represent certain industries over others.

Sources: MSCI, Bloomberg, Seafarer.

Communication Services, Information Technology, and Financials are over-weighted by the MSCI EM Index when measured relative to the positive benchmark. Conversely, Industrials, Energy, Real Estate, and Health Care are under-weighted in the MSCI EM Index. Notably, these sector clusters roughly mirror the prior discussion of capitalization’s effect on sector allocation.

When replicated across trillions of dollars in capitalization in EM equities, the systematic exclusion and de-emphasis of small-cap companies has consequences for benchmark-driven investors: significant distortions of industry and capitalization exposures. Ironically, MSCI’s own authors have written on the investment drawbacks of “a negative view on the small cap premium,” citing historical analysis of all-capitalization indices outperforming large- and mid-cap-only indices.⁸

Individual Constituent Rankings and Weights

An analysis of the weightings and ranks of the MSCI EM Index’s top 10 constituents (Figure 8) acts as a proxy for comparing the overlap between the normative and positive benchmarks. Specifically, it offers a closer look at how the index’s sampling criteria and filters affect investments at the constituent level. Some of the top constituents in the normative index receive weightings several times higher than in the positive benchmark, as shown in Figure 8. In aggregate, the top 10 constituents in the normative MSCI EM Index receive a 25% weighting, about 50% above the positive benchmark’s 17%. Furthermore, two semiconductor producers – TSMC and Samsung Electronics – are weighted about four times relative to the positive benchmark. While some added concentration is inevitable when going from population to sample (index), the distortions at the individual stock level are large and uneven.

Conclusions of Part II

There are marked differences in the investment exposures provided by the normative and positive index approaches. Indeed, the MSCI EM Index has certain inherent statistical biases that arise from its normative approach: its subjective emphasis on “investability and replicability” has resulted in active tilts away from large swaths of the emerging markets, as summarized in Figure 9.

While the positive benchmark may not suffer from subjective sampling biases, an obvious argument against a positive index is the time and difficulty involved in its replication.

Practical considerations may force index providers to make tradeoffs between commercial adoption and unbiased representation of the underlying market structure. Many individual investors still think of their passive investments as free of active skews. But index providers face expectations from their clients to create a product that scales well and easily accommodates large numbers of benchmarking investors, and this has direct investment implications.

In the meantime, institutional investors – such as event-driven funds – can be more opportunistic about the inefficiencies that indexed pools of capital generate, including by anticipating stock additions ahead of formal announcements.

The effect of prices rising ahead of index additions becomes even more pronounced with some smaller EM markets. For example: Qatar, United Arab Emirates (UAE), and Pakistan are the three markets that recently graduated from frontier to emerging market status under MSCI’s classification system. The countries’ stock markets each rose in the roughly one year that fell between the announcement of their inclusion and the subsequent implementation. Qatar rose +54%, Pakistan rose +28%, UAE surged +99%. But in the twelve months subsequent to the effective inclusion date, their buying direction reversed; Qatar, UAE, and Pakistan’s MSCI indices returned -22%, -23%, and -29%, respectively.¹⁰ The data suggests that active sellers pre-emptively took advantage of passive buyers: investors that bought ahead of effective index inclusions have profited at the expense of passive investors constrained to pre-scheduled market entry and exit points.

A second critique of emerging market indices is that they are backward-looking in at least two ways. The first is that a passive methodology gives the largest weighting to those companies whose valuations have already appreciated meaningfully. In the developed markets, this has led to criticism of indices as “pro-cyclical” or “momentum-driven,” because float-based weightings are at their highest when market valuations peak.

The situation in the emerging markets adds a secular element in that different countries’ economies and relative economic rankings are still in flux. The countries best positioned to drive tomorrow’s growth are not necessarily the same ones that have already had years of rapid economic development. Rather, tomorrow’s high-growth markets may have low capitalizations today but possess the raw materials for future growth: a young working population, stable political and monetary regimes, and a consumer class that is positioned to upgrade everything from education to cooking oil.

1. “MSCI GLOBAL INVESTABLE MARKET INDEXES METHODOLOGY,” MSCI, February 2019.
2. Tracy Alloway, Dani Burger, and Rachel Evans, “Index Providers Rule the World—For Now, at Least,” Bloomberg Markets, 26 November 2017.
3. Methodology note: we define an objective benchmark as comprising companies with an equity market capitalization of at least USD 100 million in 26 EM countries, as defined by MSCI. Argentina, Brazil, Chile, China, Colombia, Czech Republic, Egypt, Greece, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Pakistan, Peru, Philippines, Poland, Qatar, Russia, Saudi Arabia, South Africa, Taiwan, Thailand, Turkey and United Arab Emirates.
4. “MSCI Emerging Markets Index (USD) Brochure,” MSCI, 29 March 2019.
5. As of 31 December 2018.
6. “Further Weight Increase of China A Shares in MSCI Indexes”
7. “MSCI eyes near-doubling of China weighting in EM index”, Financial Times, 25 September 2018.
8. “ACWI Index Brochure,” MSCI, December 2018.
9. Raina Oberoi and Anil Rao, “Evaluating Emerging-Market Stocks through a Governance Lens,” MSCI, 21 February 2019. MSCI uses the following definitions: controlled SOEs as companies that have one or more sovereign entity investors controlling 30% or more of the company’s total voting power; principal shareholder companies as those with one or more investors that hold at least 10% but not more than 30% of the company’s total voting power; controlled founder firms as having one or more company founders holding 30% or more of the company’s total voting power and also serving as the company’s chief executive officer or chairman; controlled family firms as those having one or more family groups holding 30% or more of the company’s total voting power; other controlled companies as those with one or more investors, not identified as either company founders or representing family interests, holding a combined voting block of 30% or more; and widely held companies as those lacking any single investor holding 10% or more of the company’s total voting power.
10. Indices used are MCQA Index (Qatar), MXAED Index (United Arab Emirates), MXPK Index (Pakistan). Sources: MSCI, Bloomberg, Macquarie.

MSCI Emerging Markets Index is a free float-adjusted market capitalization index designed to measure equity market performance of emerging markets. Index code: MXEF. MSCI Emerging Markets Investable Market Index (IMI) is an all-cap index that represents emerging market countries. Index code: MXEFIM. CSI 300 Index is a free-float capitalization-weighted index designed to replicate the performance of the top 300 Chinese A-Shares traded on the Shanghai and Shenzhen stock exchanges. Index code: SHSZ300. MSCI Qatar Index is a free-float adjusted index designed to measure the performance of the large- and mid-capitalization segments of the Qatari market. Index code: MCQA. MSCI United Arab Emirates (UAE) Index is an index designed to measure the performance of the large- and mid-capitalization segments of the United Arab Emirates (UAE) equity universe. Index code: MXAED. MSCI Pakistan Index is an index designed to measure the performance of the large- and mid-capitalization segments of the Pakistan market. Index code: MXPK. It is not possible to invest directly in an index.

As of December 31, 2019, Taiwan Semiconductor Manufacturing Co., Ltd. comprised 2.4% of the Seafarer Overseas Growth and Income Fund, Samsung Electronics Co., Ltd. comprised 4.8% of the Fund, and Alibaba Group Holding, Ltd. comprised 4.8% of the Fund. View the Fund’s Top 10 Holdings. Holdings are subject to change. As of December 31, 2019, the Seafarer Funds did not own shares in the other securities referenced in this commentary.

The views and information discussed in this commentary are as of the date of publication, are subject to change, and may not reflect Seafarer’s current views. The views expressed represent an assessment of market conditions at a specific point in time, are opinions only and should not be relied upon as investment advice regarding a particular investment or markets in general. Such information does not constitute a recommendation to buy or sell specific securities or investment vehicles. It should not be assumed that any investment will be profitable or will equal the performance of the portfolios or any securities or any sectors mentioned herein. The subject matter contained herein has been derived from several sources believed to be reliable and accurate at the time of compilation. Seafarer does not accept any liability for losses either direct or consequential caused by the use of this information.