MSCI Changes Recast Frontier Exposures

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MSCI's index review on June 11 brought the most significant and eventful country reclassifications in recent years. Now it's time to dive into what all those changes will mean for existing ETFs .

The last time MSCI made a significant country reclassification was in May 2010, when it upgraded Israel from emerging to developed status (a year later in May 2011, it did yank Trinidad & Tobago out of frontier-but that was an insignificant event to ETF investors at the time).

In this year's review, four countries were either upgraded or downgraded. Greece was demoted from developed to emerging, while Morocco was demoted from emerging to frontier. Meanwhile, UAE and Qatar were promoted to emerging from frontier.

I think Greece's demotion was not only expected but also somewhat of a yawner. Greece's presence in the $41.6 billion iShares MSCI EAFE Index Fund (NYSEArca:EFA) is currently less than 0.10 percent.

Even when Greece jumps into the $35 billion iShares MSCI Emerging Markets Index Fund (NYSEArca:EEM), with Coca-Cola Hellenic no longer a part of the MSCI Greece Index-the bottling giant formerly made up close to one-third of Greece's entire index-Greece's presence in EEM is likely to be miniscule.

The most significant changes will be felt in the frontier landscape. Perhaps the most affected ETF will be the $224 million iShares MSCI Frontier 100 Index Fund (NYSEArca:FM), which holds 100 of the largest, most liquid and investable companies from frontier markets, per MSCI's classification framework.

Currently, Qatar makes up 18 percent of the fund and UAE makes up 14 percent (a combined 32 percent). Of the 100 holdings in FM, 23 are currently from Qatar and UAE. This means that once the changes are implemented, roughly one-fifth of the entire fund's portfolio will be replaced with securities from other markets.

This may initially create uncertainty for investors in FM, but I don't necessarily see this as a negative event. In fact, I touched on this in a previous blog when FM first launched in September 2012, but the promotion of Qatar and UAE might actually provide more regional diversification to a fund that's highly concentrated in the Middle East region (more than 60 percent).

With 32 percent of the fund's weighting freed up, that weighting will need to be reallocated to other securities from other markets, potentially boosting exposure to other countries like Nigeria, Pakistan, Kenya, Kazakhstan, Vietnam and Sri Lanka.

From a sector perspective, more than 50 percent of FM is also currently allocated to financials. Of that 50 percent financial exposure, more than 9 percent comes from Qatar and more than 10 percent comes from UAE. Without those countries, FM's financials exposure could decrease to provide a more sector-diverse fund.

Of course, there's always the possibility that the exclusion of Qatar and UAE might also boost the already-massive 26 percent weighting in Kuwait. Currently, the index caps a single country to 50 percent, so Kuwait can potentially carry an even bigger hand in the fund. It's not a certainty but a possibility that's good to be aware of.

Finally, let's not forget Morocco. The North African country was also demoted to frontier, which means Moroccan companies should eventually be eligible for inclusion into FM. While Morocco's weighting in EEM is a measly 0.01 percent, Morocco should become a bigger fish in a smaller pond in FM (I wouldn't be surprised to see some Moroccan companies in FM in the coming year).

Important to note is that while MSCI announced the reclassifications last week, the actual changes in the MSCI Frontier Index for Qatar and UAE won't be implemented until May 2014, which will give investors and funds like FM nearly a full year to prepare for the changes.

For Morocco and Greece, the changes will be implemented sooner-currently scheduled for November 2013. That's why we'll likely see changes in exposure to Morocco before Qatar and UAE in iShares' FM.

Still, even after the MSCI reconstitution in FM, investors wanting more Qatar and UAE exposure should still have plenty of other ETF options. Qatar and UAE make up close to 70 percent of the WisdomTree Middle East Dividend Fund (NYSEArca:GULF).

In the Market Vectors Gulf States Index ETF (NYSEArca:MES), which tracks a Dow Jones Index, Qatar and UAE make up 56 percent, while the PowerShares MENA Frontier Countries Portfolio (NYSEArca:PMNA), which tracks a Nasdaq Index, allocates 53 percent to the two gulf countries.

For those wondering about the $99 million Guggenheim Frontier Markets ETF (NYSEArca:FRN), I haven't forgotten. There just isn't much to say about that fund because this recent reclassification has no effect on it.

FRN not only has zero exposure to Qatar and UAE-it tracks a BNY Mellon index that's composed of depositary receipts anyway-more than 70 percent of the fund consists of Chile, Colombia and Peru, countries that are all classified as emerging by major index providers like MSCI, FTSE and S&P.

At the end of the day, I don't think any of the recent reclassifications came as a shock. MSCI has been very transparent about its review process, and I think the outcome of this past review was expected.

As for the coming changes in iShares' FM, I don't see the eventual exclusion of Qatar and UAE as a negative development. In fact, it may even enhance the fund's attractiveness from a regional and sector-diversification perspective.

Don't forget to check IndexUniverse.com's ETF Data section.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: Investing , ETFs

Referenced Stocks: EEM , EFA , FRN , MES , PMNA

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