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Index compiler MSCI Barra announced earlier this week that Israel will be reclassified from emerging market status to developed market status, forcing some of the largest ETFs on the market to do some rebalancing in the coming months.

Israel will be removed from the MSCI Emerging Markets Index and the MSCI EMEMEA Index, which includes emerging markets in Europe, the Middle East, and Africa. The MSCI Israel Index will now be included in the MSCI World Index, where it is expected to rank 18th out of the 24 developed market member countries, ahead of Portugal and Ireland.

Making the Grade

MSCI regularly reviews and classifies 75 of the world's largest markets into one of three categories:

  1. Developed,
  2. Emerging, and
  3. Frontier.

MSCI evaluates all covered markets on 18 measures in four market accessibility criteria, including:

  • Openness to foreign ownership
  • Ease of capital inflows / outflows
  • Efficiency of the operational framework
  • Stability of the institutional framework

In evaluating these areas, MSCI attempts to reflect the views of international investors, who generally emphasize equal treatment of investors, free flows of capital, cost of investment, and company-specific risk.

Korea, Others Stay Put

Analysts had widely expected South Korea to join Israel in its promotion to developed nation status, but several items apparently caused significant concern to MSCI. Among the primary factors preventing Korea's elevation are the lack of full convertibility of the won, the rigidity of the identification system, and presence of anti-competitive practices. Korea will remain under consideration for an upgrade in 2010, although MSCI indicated that the country will need to make "significant progress" by then. Other comments from MSCI:

  • Taiwan: Will be reviewed for promotion to Developed status in 2010. Although major progress has been made, the lack of full convertibility of the Taiwan dollar and restrictions associated with foreign investors remain areas of concern.
  • UAE: Will remain in Frontier status and will be reviewed for promotion to Emerging status in 2010. Foreign ownership limit levels are one area of concern for the UAE.
  • Qatar: Will remain in Frontier and will be reviewed for promotion to Emerging status in 2010. The lack of formal segregation between custody and trading accounts must be addressed prior to change.
  • Kuwait: Due to significant market accessibility issues, Kuwait will remain in Frontier status and will not be reviewed for promotion in 2010.
  • Greece: Identified as having the most shortcomings among Developed nations, due primarily to onerous short selling practices and prohibition of off-exchange transactions.
  • Russia: This Emerging market was noted for having significant limitations on the efficiency of its operational framework, due in part to the absence of a cental securities depository in Moscow.
  • Pakistan: In light of recent events, MSCI indicated that Pakistan will need to function without trading disruptions "for some time" before being considered for reclassification.

Impact on ETFs

Israel's elevation presents certain challenges for a number of ETFs that will be required to rebalance their holdings. Failure to complete a rebalancing in a timely and cost-efficient manner is one of the primary sources of tracking error for ETFs relative to their underlying index. The indexes can simply "flip a switch" and begin including (or excluding) Israel's equity markets.

But since ETFs actually hold the underlying components of these indexes, they must go out into the market and buy or sell Israeli equities to ensure that their holdings continue to mirror those of the index. Given the size of indexed funds and ETFs, reclassifications can lead to significant demand for new index components, driving up prices. Israel accounted for approximately 2.8% of the Emerging Markets index and 13% of the MSCI EMEMEA Index. It will likely account for less than 0.5% of the World Index.

Although the promotion signals that Israel's financial markets are on par with other developed nations, stock prices actually fell on the news. Emerging markets funds have led the recent global equity market recovery, attracting hundreds of millions of dollars of cash inflows and driving up prices for constituent stocks. With Israel now moving up in the world, emerging markets funds, which include two of the largest 15 ETFs by market cap, will be dumping their holdings, potentially depressing prices.

ETFs due for a rebalancing could include:

Note that the State Street funds included above track emerging markets indexes maintained by S&P / BMI that presently include Israel. While a rebalancing isn't imminent on these funds, it's likely that these indexes will follow MSCI's lead and reclassify Israel eventually.

Disclosure: No positions.

Source: Israel's Promotion Spurs Shakeup for ETFs