MSCI revision alters frontier markets' makeup

Institutional investors' exposure to emerging markets and frontier markets is set for big changes following the reclassification of two Middle Eastern countries by MSCI Inc.

On June 2, Qatar and the United Arab Emirates will move out of the MSCI Frontier Markets index and into the MSCI Emerging Markets index. Both countries have long campaigned for entry to the emerging markets club.

The change carries implications not only for the indexes and the countries in them, but also for institutional investors. Those tracking the EMI will gain exposure to the oil-rich markets, and those investing through the FMI will have more exposure to fast-growth economies such as Nigeria and Kenya. The change will increase the Frontier Markets index's exposure to markets in Africa, Asia and Latin America, said money management executives.

“When the U.A.E .and Qatar leave there will be other markets that will be much more important — Kuwait and Nigeria for example,” said Maarten-Jan Bakkum, The Hague, Netherlands-based senior emerging market strategist at ING Investment Management. “These two will then be by far the biggest markets in the new frontier index.”

According to information from Baring Asset Management, the Frontier Markets index has a collective 36.3% weighting to Qatar and the UAE. Kuwait has a 17.6% share and Nigeria, 11.7%.

On June 2, Kuwait is set to take the biggest weighting, at 26.6%, and Nigeria will come in second, at 18.7%. Barings said in a note alongside its data on the new index that the reclassification “will proportionately increase the exposure to the long-term growth potential markets in Africa, Asia and Latin America, as well as other markets in the Middle East such as Kuwait and Oman.”

“Investors want (exposure to) countries that have the significant potential to change over the next 10 years, have a rising middle class, developing financial markets and products — that is definitely not the (Middle Eastern countries),” said Josef Odili, London-based head of Africa research at money manager RisCura.

Patrick Esteruelas, head of sovereign research at emerging markets specialist Emso Partners Ltd., based in New York, said while the Frontier Markets index returns might suffer following the departure of Qatar's and the UAE's “strong equity markets, the new portfolio of companies in the index will represent a greater exposure to lower-income countries, with potentially higher growth profiles — but also greater volatility.”

Money manager executives say the change will reduce the index's reliance on Middle Eastern countries to produce returns, and give institutional investors more diversification.

“One of the biggest issues with investing in frontier markets is how dominant the (Middle Eastern countries) were in the index — Kuwait, the UAE and Qatar represented over 50% of the index,” said Mr. Odili.

Managers say there will be an opportunity for institutional investors to discover new sources of return in frontier markets.

“The (Frontier Markets index) will be much more global. The index was dominated by these very rich, high-growth frontiers in the group,” said Mr. Bakkum. Qatar's GDP per capita was almost $94,000 as of Dec. 31, 2012, according to the World Bank, compared with almost $3,000 for Nigeria and almost $52,000 for the U.S.

“With Dubai, Abu Dhabi and Qatar gone, frontier investors will have to look harder at places in equatorial Africa and frontier Asia for new opportunities,” said Mauro Ratto, head of emerging markets at Pioneer Investments in London. “That can be challenging given prevalent valuation distortions stemming from variable liquidity.”

According to the eVestment LLC frontier markets equity database, institutional investor net inflows to the asset class were $577 million in the three months ended Dec. 31, compared with net outflows of $139 million for the same period 2012.

Institutional assets under management in the frontier database was $4.9 billion at year-end 2013, up 74% from the previous year.

The MSCI Frontier Markets index gained 25.87% for the year ended Dec. 31, and is up 12.36% year-to-date through May 20.

That is in high contrast with the MSCI Emerging Markets index, which was down 2.25% in 2013, and is up 3.42% year-to-date through May 20. Both frontier and emerging markets are also up relative to the MSCI World index, which year-to-date through May 20 gained 2.3%.

But investors could be in for a hit post-reclassification. “The Frontier Markets index did well for several reasons — one reason being that mainstream emerging markets were struggling,” said Mr. Bakkum. “At the same time, Gulf markets did well, with a lot of consumption driven by strong rates growth. I'm not so sure what investors will do — whether there will be less interest in (frontiers) as these successful markets leave, or more as it is a more global index now.”

There will also be the issue of lower liquidity.

“One of the biggest problems in (frontier markets) is liquidity — if a lot of managers are launching frontier markets funds and investors pour into them, that is pushing up prices,” said Oliver Kettlewell, senior investment research analyst at Morningstar OBSR, an investment research and consulting business, based in London. “But if there are problems in those markets and everyone rushes for the door, then selling stocks that don't trade very well could be an issue.”

“The UAE and Qatar are expected to represent around 0.6% and 0.5% of the Emerging Markets index, respectively,” said Brendan Bradley, Ph.D., director, portfolio management at Acadian Asset Management in Boston. “While this may be small, it's larger than existing allocations to Hungary, Egypt, Czech Republic and Peru — it's about the same size as the current allocation to Greece.”

Even this small exposure to markets that have been successful could attract investors to an index that has taken hits from the effects of quantitative easing and rallying developed markets in the recent past, said Mr. Bakkum.

Some investors are getting ready for the reclassification.

“The upgrade for (the UAE) and Qatar has seen active investors include key constituents in their portfolios over the past six months, ahead of the actual upgrade taking effect,” said Peter Gotke, London-based managing director in Bank of New York Mellon Corp.'s depository receipts business. “The passive investors typically adjust their portfolios on the eve of the upgrade, so this will be more noticeable at the very beginning of June.”

He said both countries could attract up to $2 billion in new investment from the combination of active and passive investors.

Mr. Kettlewell said some portfolio managers look to the Middle Eastern countries as a “safe haven. They behave in different ways, (so there is) more diversification. If there is social unrest in Brazil, or political unrest in Russia, fund managers can hide away in the Middle Eastern markets,” he said.

But he warned that the flip side is that Qatar and the UAE markets have lower liquidity than other emerging markets. A money manager with bigger emerging markets funds “would struggle to allocate a lot of their portfolios to these countries, as they could literally move markets with their positions. It is the same for pension funds,” said Mr. Kettlewell.

Other money managers have not been convinced by the Middle Eastern markets anyway.

“We have been underweight the Gulf — including Qatar and the UAE,” said frontier markets-focused Gabriel Sacks, investment manager, emerging markets equities, at Aberdeen Asset Management, London. “For us, (the reclassification) means the (frontier markets) benchmark moves closer to our frontier markets fund.”

He said the reclassification will have no effect on the way the manager invests in frontier and emerging markets, because it is an active stock picker, looking at the strength of companies for its exposure. n