A few weeks ago, I had the pleasure of participating in an IndexUniverse webinar with MSCI. The topic du jour: “Building a High Caliber ETF Portfolio: How Institutional Investors Approach Index Selection.” The replay can be found here, for anyone who’s interested.
The timing of this conversation couldn’t have been better. With all of the ETFs available in the market today, it has become increasingly important for investors to understand not only the ETF they’re investing in, but also the index that it seeks to track. Why? Because 2 indexes that sound similar can have varying exposures, which can lead to a meaningful difference in risk and return characteristics.
A good example of this is in the emerging markets space. Emerging markets are generally defined as countries with expanding economies with established (though evolving) equity capital markets. Contrast that with developed markets, which typically have more advanced equity markets and well-formed regulatory bodies. Often investors only associate emerging markets with growing and evolving economies but pay little attention to how well the equity capital markets function.
Within Emerging markets, let’s take Pakistan as an example. MSCI, Russell and S&P all classify Pakistan as a frontier market (which are typically characterized by their less stable equity markets), whereas FTSE includes it in its Emerging Markets Index.
In the eyes of MSCI, Pakistan actually used to be an emerging market. However, in 2008 Pakistan imposed a “price floor rule” on the Karachi Stock Exchange, which effectively shut down the equity market for 5 months. When the floor was removed and trading resumed, market levels collapsed (see below). This event was substantial enough for MSCI to demote Pakistan to the Frontier Markets Index, because it proved that the equity market system there was too unstable to be considered an emerging market.
Now, this is just one example of how index provider rules can affect exposure, but it illustrates the point that 2 indexes with similar names are not necessarily interchangeable. To be clear, I’m not saying that one index is “bad” and another is “good”, but rather that I simply believe that exposure matters. If an investor has decided to add frontier markets exposure to their portfolio, the ETF they select should reflect that. Likewise if the desired exposure is emerging markets, an ETF with frontier markets exposure would be less than precise.
So how do investors decide which index is right for them? For starters, you might check out the list of criteria for evaluating a benchmark index that my colleague Dodd Kittsley outlined in a recent blog post.