By Tim Batho, senior index policy strategist
“It’s the economy, stupid” was a message posted onto the wall of a US presidential candidate’s war room in the early 1990s. The intention was to remind campaigners that the key message and battleground was economic wellbeing of the electorate.
For some professional investors looking at emerging market (EM) exposure, the same message—without the insulting last word—holds true: they gauge their exposure on a variety of measures pertaining to the current, and likely future performance of EM as a sector, or of countries within it. But for index providers and many other market participants, assessing whether a country is developed, emerging, or frontier, based on these pure economic measures is not the sole, or even main, consideration.
This approach is perhaps in part, derived from the first recorded usage of EM was by the International Finance Corporation of the World Bank in the early 1980s. They used the term “emerging market economy” to define a country with low to middle per capita income. Most readers would recognize that this now represents a relatively narrow definition.
Even today, the term “emerging market” is often loosely used, and it’s clear that from an economic perspective the countries that fall into this category can vary hugely in size and complexity.
Clearly investors allocating to emerging markets require a rigorous, consistent and transparent definition. So, based on client feedback received through our advisory committees, FTSE Russell considers the emerging market definition primarily from an investment, regulatory, operational and market accessibility perspective and, specifically, from the position of an international investor. This forms the basis of 21 relevant criteria. Macro economic considerations in themselves are a smaller part of the consideration than these factors, although one might expect some correlation between economic performance and market accessibility.
Since 2003, we have maintained an evidence-driven equity country classification framework to help the investment community evaluate the evolutionary stage of equity markets.
The framework incorporates the full spectrum of country classifications, spanning from frontier, through emerging, to developed market status.
The table below shows the FTSE classification of equity markets as at March 2019.
*Saudi Arabia reclassification to Secondary Emerging market status commenced from March 2019 will be completed by March 2020.
**China A Shares to be reclassified as Secondary Emerging status within the FTSE Global Equity Index Series (GEIS) commencing June 2019 and to be completed by March 2020.
***Iceland to be reclassified as Frontier, effective with the annual review of the FTSE Frontier index in September 2019.
Source: FTSE Russell as of March 2019. Past performance is no guarantee of future results. Please see disclaimer for important legal information.
Our equity Country Classification scheme
The framework seeks to recognize a broader array of criteria that has greater relevance to the majority of the investment community. This is a more robust methodology than a classification based primarily on relative market wealth, economic strength and political development.
Our equity Country Classification scheme assesses 21 relevant objective criteria across four segments:
- Custody and Settlement;
- Dealing Landscape; and
We also consider World Bank GNI per capita.
It is critically important that the market infrastructure, regulatory environment and investment processes can cope with the increased activity that occurs when a country joins a leading global emerging markets index. This may be the first time that a country’s investment markets experience such substantial investment operational demands and money flows.
The countries classified as emerging within our index classification are from an economic perspective, a relatively eclectic set of markets.
But all these countries have to meet the same nine criteria within the Country Classification framework. When the capital market infrastructure of current additions, China A-Shares and Saudi Arabia, are compared with their index peer group, there is far more commonality than differences, particularly in relation to key criteria like investment access, market regulation, foreign exchange mechanisms, the settlement process and competition in the broker and custodial arenas.
For this reason, it is important that we consider the implementation timescale and process in great detail. Smaller markets may be added in a single tranche, whereas larger markets will typically be added in multiple tranches. This is to limit disruption to global markets as investment flows move between countries following a reclassification. It is also sensible to review the inclusion schedule after each early tranche, to ensure that the addition has gone as anticipated and the announced implementation plan remains appropriate. For investors, there should be no surprise implementations or decisions.
Consistently meeting the relevant criteria over a longer period of time and/or ensuring that any recent developmental changes in market practice or regulation result in improved access or efficiency for global investors remains crucial in any objective assessment. We receive feedback from FTSE Russell’s advisory committees, which inform our decisions. As practitioners, members are keen to ensure that the market is sufficiently developed such that, once added, participants are able to capture the diversification and/or return benefits offered by countries promoted to emerging market status. It is critical that we build a consensus view of a market’s classification within these important and unique forums.
Having listened closely to the views expressed and engaged with the relevant markets, the final decision about a particular country classification rests with FTSE Russell and its governance processes.
Ultimately, it is still for the asset owners and their investment advisors to determine whether the balance of risk and return inherent within any market classified as emerging fulfills the requirements of their investment strategies.
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