MSCI Index Change Would Have Big ETF Impact

It seems the Alibaba IPO was simply too big for index providers to ignore.

Roughly two weeks before Alibaba’s initial public offering (IPO), MSCI suddenly announced a consultation with investors, proposing to include what I call “misfit” stocks into its flagship Global Investable Market Index (GIMI) series.

By “misfit,” I mean companies like Alibaba and Baidu, which incorporate and list their shares outside of their home countries, thereby making themselves ineligible for inclusion into MSCI’s GIMI series.

Investors have until Nov. 28 to provide feedback, at which time MSCI will decide whether to proceed with its proposal.

Well Beyond Alibaba

While Alibaba’s been all the focus here, this proposal has broader implications for MSCI’s GIMI series far beyond the inclusion of just Alibaba.

If the proposal passes, a slew of Chinese and Russian companies, along with other “misfit” securities previously ineligible for inclusion in major MSCI indexes, are set to be added to ETFs with billions of assets in management tied to them. Not least among the funds such a change could affect is the $38 billion iShares MSCI Emerging Markets ETF (EEM | B-97).

As it stands now, most MSCI-based, U.S.-listed ETFs track indexes derived from MSCI’s GIMI series, so they follow the GIMI methodology.

Finally, if MSCI’s proposal comes to fruition, I question whether FTSE will follow suit and propose similar changes to its Global Equity Index series, which can impact ETFs like the $46 billion Vanguard FTSE Emerging Markets ETF (VWO | C-89).

China Implications

Some of the biggest changes are expected around Chinese equities. There are currently many significant and influential companies that are ineligible for inclusion into MSCI’s GIMI Indexes.

If the proposal passes, for example, Alibaba and other major Internet firms like Baidu, Ctrip.com and JD.com would become eligible, along with a host of U.S.-listed Chinese solar, consumer and health care companies.

According to MSCI, 21 additional Chinese companies would become eligible.

If you don’t think that’s relevant for a fund like EEM with 840 holdings, remember that Baidu is the third-largest holding in the SPDR S&P Emerging Markets ETF (GMM | C-86), which, like EEM, also weights by free-float market cap. (GMM tracks an S&P index already inclusive of “offshore” listed Chinese and Russian companies.)

The presence of Baidu and Alibaba would likely make the biggest immediate differences in EEM’s top holdings, which can certainly impact the fund’s returns.

Russia Implications

Similar to China, many Russian companies also incorporate outside of Russia and list their shares overseas, meaning their shares also currently get excluded from MSCI’s GIMI Indexes.

These companies include technology names like U.S.-listed Yandex, Russia’s dominant search engine; and LSE-listed Mail.ru Group; as well as consumer names like X5 Retail Group and O’Key Group.

According to MSCI, there would be nine additional Russian companies added to MSCI’s broad emerging index. That’s significant when you consider this would boost Russia’s company count by 40 percent—there are currently only 22 Russian companies in MSCI’s standard Russia index.

Country-Specific Indexes

How the proposal will ultimately impact country-specific MSCI-based ETFs isn’t totally clear.

Looking at the China example again, according to MSCI, the 21 additional names would all be added to a new “overseas China” index. This new index would then be combined with the standard MSCI China Index to produce a new “Global China” Index, which would roll into the parent MSCI EM Index, which EEM tracks.

Immediately coming to mind is how this would affect the $1.2 billion iShares MSCI China ETF (MCHI | B-39), which tracks the standard MSCI China Index. Whether iShares decides for MCHI to track the new MSCI Global China Index remains to be seen. I hope the fund does end up tracking the new China index, but there have been no announcements on that front.

Things get a bit more complicated with Russian securities. While there are nine additional securities slated for inclusion in the new “Global Russia” index (and MSCI’s broad emerging markets index), only three new companies are expected to be added to any new “overseas Russia” index.

Meanwhile, six of the nine new names are expected to be added to the standard Russia index, which is currently tracked by the $270 million iShares MSCI Russia Capped ETF (ERUS | B-94). Again, it remains to be seen if ERUS will continue tracking the standard index, or if it will track the new “Global Russia” index.

The Takeaway

MSCI’s proposals, should they come to fruition, would better represent the respective countries’ available equity universe.

We’ve long used MSCI’s indexes as our segment benchmarks for our ETF Analytics because we believe in MSCI’s strict, rules-based and time-tested methodology. Still, I’ve felt that MSCI falls short when it comes to coverage of Chinese and Russian securities.

Especially in a market like China, where state-owned financial, energy and telecom companies dominate its market cap, it’s even more relevant to include these entrepreneurial Internet, consumer and health care companies to diversify sector exposure.

Moreover, these are precisely the types of sectors that the Chinese government is deliberately attempting to reorient China’s growth model toward in the coming decades.

Same with the Russia fund ERUS, which is dominated by state-owned energy companies: Adding these new companies would further provide sector diversification.

Not About Returns

I don’t view this proposal as trying to snatch Alibaba and other Chinese Internet companies for purposes of returns. The relevance behind their inclusion goes beyond performance expectations.

To an indexer, this is more about having the most comprehensive exposure to a country’s equity market for investors looking for the broadest beta coverage to a specific country or region.

I welcome this proposal and hope it passes. I look forward to seeing some significant changes in some of the largest ETFs in the world.

At the time this article was written, the author held no positions in the securities mentioned. Contact Dennis Hudachek at [email protected], or follow him on Twitter @Dennis_Hudachek.