Emerging markets: changing definitions

In the quarter century since MSCI launched the first comprehensive emerging markets index, equity investors have grown more comfortable with the idea of investing in developing markets. The MSCI Emerging Markets Index has become the de facto benchmark for such investments.
But the 21 countries in the MSCI EM index include South Korea, with the world’s 12th-largest GDP, and Taiwan, which ranks 20th. Should these heavyweights be in your clients’ emerging markets allocation?
“Whether the fund has Korea or not, the diversification benefits have been the same,” says Patricia Oey, senior fund analyst at Morningstar. Korea constitutes about 15% of the MSCI EM benchmark, but has been out of the FTSE EM index since 2009. Even so, notes Oey, the performance of both indexes has been very similar over the last three years.
“If advisors are using passive funds for exposure, they should stick to one index family,” she adds. Doing so avoids the dangers of either double counting or eliminating certain countries.
At T. Rowe Price, managers of the EM portfolio use MSCI as a benchmark to avoid overlap with developed markets portfolios. “If it’s not in the developed indices, it’s pretty much fair game for us,” says Todd Henry, emerging markets equity portfolio specialist at the company, who notes that EM managers also can invest in what are sometimes called “frontier” markets.
Definitions can change over time. Argentina was once considered a developed market. It then slid to the emerging markets list and is now classified as a frontier market.
Korea and Taiwan may eventually be reclassified. “If South Korea is promoted to developed market status,” asks Henry, “then what takes the place of South Korea?” Many emerging markets can’t handle the additional investments that a re-weighting of the EM universe would entail. Henry cites the Indian market, which has a relatively small free float, as an example.