This In Practice piece gives a practitioner’s perspective on the article “Investing in the Presence of Massive Flows: The Case of MSCI Country Reclassifications,” by Terence C. Burnham, Harry Gakidis, and Jeffrey Wurgler, published in the First Quarter 2018 issue of the Financial Analysts Journal.
What’s the Investment Issue?
In June 2014, MSCI upgraded Qatar and the United Arab Emirates from its frontier-markets index to its emerging-markets index after the two countries made improvements to their markets. In May 2017, Pakistan graduated from frontier-market to emerging-market status. What are the effects of these types of reclassification on investors’ portfolios?
Market reclassification does not happen often, so investors do not always factor its potential effects into estimating their expected portfolio returns. But with some $10 trillion of assets benchmarked to MSCI’s developed-, emerging-, frontier-, and standalone-markets indexes, changes in the composition of these indexes could have a material impact on investment flows. The authors determine that benchmarkers own about half of a given emerging market, meaning that changes in emerging-markets index classifications are particularly meaningful.The authors analyze the effects of market reclassifications—upgrades and downgrades—and suggest strategies for successfully navigating the reclassification process and achieving excess returns.
How Do the Authors Tackle the Issue?
The authors investigate what happens to market returns before, during, and after reclassification. They assess the price change when a market moves from an index with more-benchmarked ownership to one with less—for example, from emerging to frontier—and vice versa. That is, they look at what happens to markets when they are either upgraded or downgraded.
Specifically, the authors consider whether a benchmarked investor should buy or sell a reclassified market at the time the reclassification is announced or wait until the reclassification actually occurs. They also examine what happened to the market’s value a year after the reclassification, seeking to understand whether upgrades to indexes are always good for markets and downgrades always bad.
Looking at 17 MSCI reclassifications between 2000 and 2015, the authors analyze changes in valuations during the reclassification cycle. They also consider the best investment strategies for extracting alpha from the reclassification cycle and when to implement these strategies.Noting that it is impossible to measure accurately the flows of capital during the reclassification cycle, the authors use estimates for the flows in their study.
What Are the Findings?
When a market is upgraded (e.g., from frontier to emerging), its MSCI country index rises, on average, by 23.2% between the announcement date and the effective date (when the reclassification occurs). A year after the reclassification, most of this extra performance is given back through a –12.4% return.
Similarly, when a market is downgraded, the average performance between the announcement date and the effective date is –12.5%. A year later, the market enjoys a 23.3% return.
So, at least on the basis of this modest sample size, the longer-run performance is roughly flat—regardless of whether a market is upgraded or downgraded.
Armed with this performance information, the authors identify some potentially successful investment strategies for several categories of investors. First, if a market is downgraded from, say, emerging to frontier status, investors benchmarked to the frontier index should buy when the reclassification occurs (the effective date of the reclassification), which not only avoids the tracking error of buying before that date but also sidesteps the negative returns between the announcement and the actual reclassification. Similarly, if a market is upgraded from frontier to emerging, investors benchmarked to frontier markets should sell their holdings around the time of the reclassification.
From the perspective of an investor benchmarked to emerging markets, buying when a frontier market is upgraded avoids tracking error but means that the investor buys at the market’s high point—before it reverts. This investor has two options for improving performance: Buy when the reclassification is announced and hold for the long term, or buy well after reclassification when the valuation has both risen and reverted. Both options introduce tracking error.
As mentioned earlier, the caveat to the potential success of these strategies is that the flows of capital during the reclassification process are estimates, not measurements.
What Are the Implications for Investors and Investment Professionals?
Flows and pricing effects associated with index reclassifications are too often ignored. This oversight can prove expensive. Investors cannot afford to miss out on the large returns available before, during, and after reclassifications and thus should include reclassification scenarios in their investment strategies and processes. At the same time, benchmarked investors must be mindful that alpha-seeking strategies may come at the cost of increased tracking error.
A simplistic “upgrades = good, downgrades = bad” approach may not bear fruit. Upgrades are not permanently good, and downgrades are not permanently bad. Instead, alpha is available to different investors at different moments in the reclassification cycle.A final word of caution: Using rough estimates for the reclassification flows may affect how much alpha is actually available. For instance, some fund managers can reallocate internally between portfolios, and thus market flows are not affected. Other funds may decide not to reallocate at all for fundamental or investability reasons and may reallocate only with a long lag.