Emerging market indices

A classification, not a description 

Emerging market sounds like a statement about an economy, and it is not one. It is a label assigned by index providers to a stock market, against published criteria that are mostly about the market rather than about the country behind it: the number and size of companies that meet minimum liquidity thresholds, how freely a foreign investor can buy and sell them, whether the currency can be converted and repatriated without restriction, how settlement and custody operate, and how stable the regulatory framework has proven.

The consequence is a set of classifications that regularly surprise people. Wealthy economies with restricted or thinly traded markets are classified as emerging, and much poorer economies with open, well settled markets sit in the same bracket. Providers also disagree with one another: a market can be classified as developed by one provider and emerging by another at the same moment, which is exactly the position several Asian markets have occupied for years. There is no single authority, and the classification a reader encounters depends on which provider's index they are looking at.

The contracts in the group 

The instruments the ledger carries that sit in or near this classification are India 50, South Africa 40, Turkey 30, Poland 20 and China A50. Each is the headline benchmark of its own market and each is dominated by a small number of sectors.

• India 50. The large capitalisation benchmark of the Indian market, weighted by free float capitalisation and dominated by banks and financial services, information technology services, energy and consumer companies. It is one of the largest and most liquid emerging equity markets, and it carries a substantial domestic investor base, which makes it less dependent on foreign flows than most of the group.
• South Africa 40. A short list concentrated in mining and resources, financials and a small number of globally listed companies whose earnings come from outside the country. Commodity prices and the rand reach it directly, and the currency is one of the most actively traded emerging currencies, which ties the index to global risk sentiment through that channel.
• Turkey 30. The headline benchmark of a market that has repeatedly experienced high domestic inflation. A nominal index level in a rapidly depreciating currency can rise steeply while the same index measured in a hard currency falls, and the two statements are simultaneously true. This is the clearest case in the class of why the currency of denomination is not a detail.
• Poland 20. A concentrated central European benchmark, heavy in banking and energy, denominated in a floating currency outside the euro. It sits at the boundary of the classification and has been reclassified upward by at least one provider.
• China A50. The onshore mainland Chinese benchmark, subject to capital controls and to restricted foreign access, and therefore the clearest example in the group of accessibility rather than economic size determining the label.

What separates the group from developed indices 

Four properties recur across the group, and they are structural rather than incidental.

1. The currency carries as much of the result as the index does. Emerging currencies move further and faster than developed ones, and an unhedged position in an emerging index expresses both movements at once. In an inflationary market the currency effect can dominate the index effect entirely.
2. Liquidity is thinner and more concentrated. Fewer constituents meet institutional size thresholds, and the largest few carry a disproportionate share of both the weight and the traded volume. Quoted spreads on the derivative are wider as a result, and they widen further outside the local cash session.
3. Foreign capital is a larger share of the marginal buyer. Where domestic institutional savings are small, a shift in global risk appetite can move an emerging index without anything having changed domestically, which is the mechanism behind the group's high correlation with one another during global stress episodes.
4. Policy risk is a live variable rather than a background assumption. Capital controls, repatriation rules, foreign ownership limits, transaction taxes and administrative interventions are all changeable, and each of them changes the terms on which the market can be accessed rather than merely the outlook for its companies.

The third point deserves the qualification that it is not universal. Markets with deep domestic pension and retail savings systems, of which the Indian market is the clearest example in this group, are far less dependent on foreign flows than markets without them, and they behave correspondingly less like a single asset class during global stress.

Inclusion and reclassification flows 

Because so much capital is invested against index benchmarks rather than against individual selections, a change in classification is itself an event. When a provider announces that a market will be added to a widely tracked emerging index, every fund tracking that index has to buy the constituents on the effective date, and when a market is removed or downgraded the same flow runs in reverse. Providers publish consultation results and effective dates well in advance for exactly this reason, so the flow is known before it occurs.

The same mechanism operates at the constituent level within a market, through the free float factor. When a state holder or a founding family sells down a stake, the shares available to the market increase, the provider raises the free float factor at the next review, the constituent's index weight rises, and tracking funds buy the difference on a published date. In markets where state and family ownership are common, these revisions are larger and more frequent than in developed markets.

Reading a level in a depreciating currency 

The most consequential arithmetic in this group is not the index arithmetic. It is the interaction between the index level and the currency it is quoted in, and it is the reason a chart of an emerging index in local currency and a chart of the same index in a hard currency can point in opposite directions over the same period.

For an account denominated in a hard currency or in a currency pegged to one, the second measurement is the one the account experiences, because the result of the contract is converted at the prevailing rate before it reaches the balance. The nominal index level is not what the account records.

Practical consequences for a contract in this group 

• Local holiday calendars differ from the developed markets and from one another, and a market can be closed for several consecutive days. The derivative may still be quoted, derived rather than computed, or its hours may be restricted; the instrument's contract specification is what states which.
• Quoted spreads are wider than on the developed contracts and vary more through the day, which raises the cost of entering and leaving relative to a movement of the same size in a deeper market.
• Margin requirements on emerging index instruments are conventionally set higher than on developed ones, reflecting the wider distribution of outcomes, and they are published per instrument rather than being uniform across the class.
• Gaps between one session and the next are larger on average, because a thinner market reprices a full day of accumulated global news in one step at the open.