MSCI Emerging Markets Index: What It Is, How It Works, and Examples

Last updated 09/11/2024 by

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Summary:

The MSCI Emerging Markets Index is a benchmark that tracks the performance of large and mid-cap stocks in 24 emerging market countries. This index helps investors gain exposure to these high-growth economies through a diversified portfolio. Emerging markets offer the potential for higher returns but also come with increased risks. In this article, we will dive into how the index works, its composition, the pros and cons of investing in it, and frequently asked questions to help you understand whether investing in the MSCI Emerging Markets Index is right for you.

The MSCI Emerging Markets Index is one of the most influential financial benchmarks globally. Launched by Morgan Stanley Capital International (MSCI) in 1988, it tracks the stock performance of large and mid-sized companies across emerging market countries. Investors use the index as a key reference to gauge the growth potential and risks of emerging economies. These markets, such as Brazil, India, and China, often demonstrate rapid economic growth and offer attractive opportunities for investors seeking high returns.

This guide will explore what the MSCI Emerging Markets Index is, how it operates, its pros and cons, frequently asked questions, and key takeaways for investors interested in emerging markets.

What is the MSCI Emerging Markets Index?

The MSCI Emerging Markets Index is a widely used benchmark that represents companies from emerging economies around the world. It is designed to capture the overall performance of large and mid-cap companies from countries that are classified as emerging markets based on specific criteria, including economic growth, market accessibility, and liquidity. The index covers approximately 85% of the free float-adjusted market capitalization in each country it includes.

Countries included in the MSCI Emerging Markets Index

As of 2023, the MSCI Emerging Markets Index includes 24 countries, spanning Asia, Latin America, Africa, and Eastern Europe. Some of the most notable countries include:

– China: As the world’s second-largest economy, China makes up a significant portion of the index.
– India: India is known for its fast-growing technology and service sectors.
– Brazi*: Brazil, with its vast natural resources, is a key player in the global commodities market.
– South Africa: As one of Africa’s most developed economies, South Africa contributes to the index through its mining and financial sectors.
– Mexico: Mexico’s proximity to the U.S. and its manufacturing sector make it a crucial part of the index.

Other countries in the index include Russia, Indonesia, Malaysia, and Turkey. These countries are typically characterized by higher economic growth rates compared to developed markets but also face higher political, economic, and currency risks.

How the MSCI Emerging Markets Index works

The MSCI Emerging Markets Index* functions as a free float-adjusted market capitalization index. This means that it only considers the market value of shares that are available for public trading, excluding insider holdings or cross-ownership stakes. The index is rebalanced periodically, ensuring that the companies included are reflective of current market conditions.

MSCI follows a rigorous methodology to determine which countries and companies qualify for inclusion in the index. Countries must meet certain standards for liquidity, market accessibility, and operational efficiency to be classified as emerging markets. Companies are selected based on their size, liquidity, and the proportion of shares available to investors.

Key sectors represented in the MSCI Emerging Markets Index

The companies within the MSCI Emerging Markets Index span a wide range of industries. Some of the key sectors include:

– Financials: Banks and financial institutions from countries like China, Brazil, and South Africa play a major role in the index.
– Technology: The technology sector, particularly in China and India, contributes significantly to the index’s performance, with companies like Tencent and Alibaba representing top holdings.
– Consumer Goods: The growing middle class in emerging markets drives demand for consumer goods, making this sector a vital part of the index.
– Energy and Materials: Many emerging market countries, like Brazil and Russia, are rich in natural resources, contributing to the prominence of energy and mining companies in the index.

How to invest in the MSCI Emerging Markets Index

Investors can gain exposure to the MSCI Emerging Markets Index through various financial products, such as exchange-traded funds (ETFs), mutual funds, and index funds. These funds track the performance of the index by investing in the stocks it includes, allowing investors to benefit from the growth potential of emerging markets without needing to purchase individual stocks from these regions.

Popular ETFs tracking the MSCI Emerging Markets Index

Several ETFs provide direct exposure to the MSCI Emerging Markets Index. These include:

– iShares MSCI Emerging Markets ETF (EEM): One of the largest and most popular ETFs tracking the index, with assets spread across multiple emerging market countries.
– Vanguard FTSE Emerging Markets ETF (VWO): Another major player, offering a low-cost way to invest in emerging market economies.
– SPDR Portfolio Emerging Markets ETF (SPEM): This ETF focuses on providing broad exposure to emerging market stocks at a lower expense ratio.

Each of these ETFs has different expense ratios, performance histories, and levels of exposure to specific countries or sectors within the index.

Direct stock purchases

For more seasoned investors who want greater control, direct stock purchases from companies listed in the MSCI Emerging Markets Index are an option. However, this approach requires more research and a better understanding of the risks associated with individual markets and companies.

Why invest in the MSCI Emerging Markets Index?

Emerging markets can offer substantial opportunities for investors looking to diversify their portfolios and seek higher returns. As these economies grow, companies in the MSCI Emerging Markets Index are well-positioned to capitalize on expanding consumer bases, increasing industrial output, and technological advancements. Investing in this index offers:

– Diversification: Exposure to different economies and sectors outside of developed markets.
– Growth potential: Emerging markets often experience faster economic growth compared to developed markets.
– Currency appreciation: In some cases, currencies in emerging markets may appreciate relative to the U.S. dollar, enhancing returns for foreign investors.

Real-world examples of emerging market performance in the MSCI index

To better understand how the MSCI Emerging Markets Index functions in practice, it is helpful to look at real-world examples of past performance.

The rise of China in the MSCI Emerging Markets Index

Over the last few decades, China has emerged as a global economic powerhouse. Its inclusion in the MSCI Emerging Markets Index has dramatically altered the index’s composition, with China now representing over 30% of the total index. Companies like Tencent, Alibaba, and Meituan have become major players, contributing significantly to the overall performance of the index.

For example, in 2020, when much of the world struggled due to the COVID-19 pandemic, China’s strong economic recovery helped bolster the MSCI Emerging Markets Index. Chinese

technology and e-commerce stocks surged during the pandemic, boosting returns for investors who had exposure to the index. This underscores how the economic trajectory of one country, especially one with a large weighting like China, can influence the overall performance of the MSCI Emerging Markets Index.

Brazil’s commodity boom and its impact on the MSCI Emerging Markets Index

Brazil, known for its rich natural resources, has experienced periods where its stock market significantly influenced the MSCI Emerging Markets Index. For instance, during the commodity boom of the early 2000s, Brazil’s major corporations—especially those in oil, mining, and agriculture—saw rapid growth. Companies like **Petrobras** and **Vale** benefited from rising commodity prices, contributing to the overall strength of the MSCI Emerging Markets Index during this time.

However, Brazil’s heavy reliance on commodities also meant that the country’s stock market became vulnerable to global commodity price fluctuations. In periods when commodity prices fell, the index reflected this volatility, particularly due to Brazil’s relatively large weighting within the index.

Political instability in Turkey and its effect on the MSCI Emerging Markets Index

In contrast to China and Brazil, Turkey provides an example of the risks involved in emerging markets. Turkey’s economy has seen significant volatility in recent years due to political instability, economic mismanagement, and currency devaluation. In 2018, the Turkish lira lost nearly 30% of its value against the U.S. dollar, causing a significant decline in the Turkish stock market.

Because Turkey is part of the MSCI Emerging Markets Index, this economic and political turmoil negatively impacted the index’s overall performance during that period. Investors with exposure to the MSCI Emerging Markets Index experienced increased volatility and lower returns due to Turkey’s economic crisis. This example highlights how political and economic risks in one country can reverberate through the entire index.

Factors influencing the performance of the MSCI Emerging Markets Index

Several factors can significantly affect the performance of the MSCI Emerging Markets Index. Understanding these can help investors make informed decisions when investing in the index.

Global economic conditions

The MSCI Emerging Markets Index is sensitive to global economic conditions, including the health of the global economy and the level of trade between emerging markets and developed economies. When the global economy is booming, emerging markets often see increased exports, higher levels of foreign direct investment, and a stronger currency, all of which contribute to positive performance for the index.

For example, when the global economy recovered after the 2008 financial crisis, many emerging markets, particularly those that rely on exports like China, South Korea, and Brazil, saw robust economic growth that contributed to the strength of the MSCI Emerging Markets Index.

Interest rate changes and capital flows

Interest rates set by major central banks, especially the U.S. Federal Reserve, can have a profound impact on emerging markets. When interest rates in developed markets are low, investors often seek higher returns in emerging markets, increasing capital inflows and driving up stock prices in these countries. However, when interest rates in developed markets rise, capital can flow out of emerging markets, leading to declines in stock prices and currency devaluations.

A notable example occurred in 2013 when the Federal Reserve began to signal that it would taper its quantitative easing program. This led to a “taper tantrum,” where investors rapidly withdrew money from emerging markets, causing stock market declines and currency depreciation in countries such as India, Indonesia, and South Africa. As a result, the MSCI Emerging Markets Index saw a significant dip during that period.

The role of currency fluctuations in emerging market investing

Investors in the MSCI Emerging Markets Index need to consider the impact of currency fluctuations on their returns. Since the index includes companies from multiple countries with different currencies, changes in exchange rates can either enhance or reduce returns for investors.

Currency depreciation and its impact on returns

If the currency of an emerging market country depreciates against the U.S. dollar or other major currencies, the value of investments in that country’s stock market can decrease when measured in dollars. For instance, if an investor holds an ETF tracking the MSCI Emerging Markets Index, and the Brazilian real depreciates significantly, the value of Brazilian stocks in the index will drop when converted into U.S. dollars, even if those companies perform well in local currency terms.

Hedging against currency risk

To mitigate the risk of currency fluctuations, some investors opt for currency-hedged ETFs or mutual funds that track the MSCI Emerging Markets Index. These funds use financial instruments to reduce the impact of currency fluctuations, offering a smoother investment experience for those concerned about currency risk. However, currency-hedged funds may come with higher fees, which can eat into returns over the long term.

MSCI frontier markets vs. MSCI emerging markets: What’s the difference?

While the MSCI Emerging Markets Index focuses on large and mid-sized companies in economies classified as emerging markets, the **MSCI Frontier Markets Index** targets smaller and less-developed markets. These are often referred to as pre-emerging markets and represent the next wave of countries that could eventually graduate to emerging market status.

Key differences between frontier and emerging markets

– Market size and liquidity: Frontier markets tend to have smaller stock exchanges with less liquidity compared to emerging markets, making it harder for investors to enter and exit positions.
– Economic development: Frontier markets are generally at an earlier stage of economic development than emerging markets, with lower levels of industrialization, infrastructure, and per capita income.
– Risk and return: Frontier markets tend to be more volatile and risky compared to emerging markets. However, they may also offer higher growth potential over the long term.

Examples of frontier markets

Countries classified as frontier markets by MSCI include **Kenya**, **Vietnam**, **Argentina**, and **Morocco**. These countries have smaller and less liquid financial markets but show potential for future growth, making them attractive to investors with a high risk tolerance. Investors should note that frontier markets carry even greater risks than emerging markets, including political instability, currency risk, and low liquidity.

When to consider frontier markets

Investing in frontier markets can be a way to diversify a portfolio further and tap into the early-stage growth of economies that may eventually become part of the MSCI Emerging Markets Index. However, due to the higher risks, frontier markets should only make up a small portion of an investor’s overall portfolio, and investors should be prepared for significant volatility.

Conclusion

The MSCI Emerging Markets Index offers a way for investors to gain exposure to some of the world’s fastest-growing economies. While it presents opportunities for diversification and potential high returns, it also comes with risks such as market volatility and political instability. By understanding these factors, investors can make informed decisions about whether the MSCI Emerging Markets Index fits their investment strategy.

Frequently asked questions

What qualifies a country as an emerging market?

Emerging markets are typically characterized by rapid economic growth, increasing industrialization, and improving infrastructure. These countries have lower per capita income levels than developed economies but show significant potential for future growth. MSCI uses specific criteria like liquidity, market accessibility, and regulatory environment to classify a country as an emerging market.

How often is the MSCI Emerging Markets Index rebalanced?

The MSCI Emerging Markets Index is rebalanced quarterly, ensuring that the index reflects the latest market conditions. MSCI may also update country classifications and add or remove companies based on their performance and market capitalization.

What are the risks of investing in the MSCI Emerging Markets Index?

Investing in the MSCI Emerging Markets Index comes with several risks, including increased market volatility, political instability, currency risk, and economic challenges unique to emerging markets. Investors should be aware of these risks when adding emerging markets to their portfolios.

Are dividends paid by companies in the MSCI Emerging Markets Index?

Yes, many companies in the MSCI Emerging Markets Index pay dividends. Investors who hold ETFs or mutual funds tracking the index may receive dividend payments, although these are typically lower than in developed markets.

Key takeaways

The MSCI Emerging Markets Index tracks the performance of large and mid-cap stocks in 24 emerging markets globally.
Investing in the index provides diversification and exposure to high-growth economies.
Emerging markets come with higher risks, such as political instability and currency fluctuations.
Popular ETFs like iShares MSCI Emerging Markets ETF (EEM) offer a low-cost way to invest in the index.
Investors should balance the potential for high returns with the higher risks involved in emerging markets.

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