What’s in a name?

Are distinctions between developed, emerging and frontier markets still useful? asks Richard Schwartz, as Global Custodian prepares to publish its annual emerging markets survey.
By Joe Parsons

What is an emerging market? The term after all suggests an economy in transition from one state to another, but the divisions between developed, emerging and frontier markets by those who use them to create investable indices have seen remarkably little movement of individual countries from one category to another.

Organisations such as MSCI, S&P and FTSE Russell all have solid metrics behind their rankings. The MSCI Emerging Markets Index, perhaps the best known in the investment world, represents the performance of large- and mid-cap securities in 24 Emerging Markets. It is built using MSCI’s Global Investable Market Index (GIMI) methodology, which is designed to take into account variations reflecting conditions across regions, market-cap segments, sectors and styles. As of March 2018, it had more than 830 constituents and covered approximately 85% of the free float-adjusted market cap in each constituent country.

The MSCI Market Classification Framework involves three broad criteria: economic development, size and liquidity as well as market accessibility. In order to be classified in a given investment universe, a country must meet a specific set of requirements in all three criteria. Market accessibility, for example, aims to reflect international investors’ experience in investing in a given market.

Indices such as those produced by MSCI are used by professional investors for investment analysis, performance measurement, asset allocation, hedging and the creation of a wide range of index derivatives, funds, ETFs and structured products.

For Charl Bruyns, head of investor services at Standard Bank Group, headquartered in South Africa, a distinction can be made between markets as investment destinations and the operational framework and infrastructure of the markets. These do not always coincide, he suggests.

Some of the distinction has to do with the nature of purchasing decisions. “The way I look at it, clients really buy the exposure they want,” says Bruyns. Some investors, for example, buy according to the MSCI indices and then allocate their money according to the weightings in the index concerned.

Value and growth

Depending on the nature and structure of a fund, asset managers may pay greater or lesser attention to each of the individual index criteria. “We don’t look at the index to determine what our portfolio weights will be,” says Mark Mobius, co-founder, Mobius Capital Partners and a renowned emerging markets investor of long standing. “Of course, when looking at investments we consider liquidity, but our emphasis is on small- and medium-size firms that don’t appear on the index necessarily.” It’s all about value and growth, Mobius adds. “We look for companies that have a strong balance sheet, pay dividends and have good prospects for earnings growth.”

Do banks and investment managers share the same concepts of risk? In buying services, for example, banks and broker dealers will often look for solutions through corridors and regions. When it comes to custody for example, broker dealers seeking high volume opportunities will come through a corridor to access those opportunities, while an investment manager wanting exposure on a portfolio is more likely to look at distinctions between market classifications according to an index provider.

A global custodian looking for service providers in a region may be looking at operational criteria that are not reflected in the indices. Bruyns takes the example of South Africa itself. “From a market maturity perspective, it’s up there with the top international markets,” he points out, “It might be seen as an emerging market because of its fundamentals, but not from the perspective of capability or operations. There are many lenses that you can use.”

In addition, says Bruyns, if you look at the size of the market versus GDP, South Africa is relatively mature. “In start-up markets, GDP is really driven by other areas of growth,” he says. “A large contribution from financial markets suggests a mature market.” For these reasons, Bruyns is sceptical of the decision by Global Custodian magazine in 2018 to move South Africa from its major markets to its emerging markets agent bank survey.

Margaret Harwood Jones, global head of securities services at Standard Chartered, makes a similar distinction between investment and operational services, though, she says, “The distinction is still very relevant to many of our clients as these classifications are used as the backbone of their investment appetite, suitability and strategies.”

As a custodian in many emerging and frontier markets, she notes, “There is direct – almost mechanical – correlation between transactions volume spikes and indices re-balancing. The intensity of these peaks can be quite extensive when a low volume / low assets-under-custody frontier market is re-classified as an emerging market, such as last year Pakistan’s upgrade into the MSCI emerging market index.”

Key questions

At the same time, the nuances and boundaries between emerging and frontier markets are becoming a little less prevalent from a post-trade perspective, she says: “We are observing an increased trend in advocacy for more alignment of local practices with global standards at securities market infrastructures (“SMI”) such as Central Securities Depository and Stock Exchanges. More mature SMIs also leverage their expertise and create joint ventures or partnerships to further develop newer securities markets (e.g. Korea Exchange and Cambodia exchange).”

In some cases, the distinction between emerging, frontier and nascent markets does not provide a clear guide to where market opportunities lie. Indeed, Mobius confirms that investment opportunities and a market’s operational framework often do not align.  “You can have a market which operationally is not in good shape, but where there are a few “hidden gems” that are worth buying,” he notes.

Standard Bank covers over 14 markets in Africa and continues to expand even where foreign access is yet to be confirmed. Not all of these markets will individually generate sufficient activity to justify stand-alone investment in capability but should be seen as part of a bigger picture.

In some markets, given their size, the economics may not at first glance appear to stack up, but if you really want to be a reliable regional bank for your client base, you have to recognise that they want a regional capability. Secondly if a bank that is established were to pull out of a market, it would send the wrong message and open up opportunities to competitors. “We need to look at these markets in the longer term and help enable them to grow. Exiting would make that more difficult,” says Bruyns.

There are some markets that may currently be subscale, but where efforts are evident to support the growth of a savings industry, a necessary underpinning for longer term success. The domestic savings industry should dominate at least 60% of the market, with perhaps 40% foreign investors coming in. But if that 60% local participation is missing in the market, the huge dominance of foreign investors brings the possibilities of sustainable growth into question, not to mention the risk of added volatility driven by foreign investor sentiment.

There are four key questions in this regard, says Bruyns. What is the local savings industry doing? What savings products are coming onstream? What are the pension fund regulations? And what moves are there to stimulate more liquidity into the market? “Those are the things that keep us interested in engaging,” he says. “Of course, custody will be the basic product and then we’ll start moving up the value chain with more product capability, but we’d need to see a sustained potential for the capital markets growth to invest in a significant capability.”

From an operational efficiency perspective, there are grounds for optimism in some of the emerging and frontier markets, whether long-established or with little or nothing in the way of legacy. Harwood-Jones suggests that new technologies, with lower entry costs, can help these markets to leapfrog some of their more developed peers. She points to West African markets such as Ghana and Nigeria that are very actively looking at distributed ledger technology proof-of- concepts in the securities space. “In ASEAN, too, markets like Thailand, Singapore, Indonesia and Malaysia have or are in the midst of shortening their settlement cycle to T+2 as they upgrade their platforms, often with SWIFT Standards,” she says.

She adds that the emergence of regional and global players can bring further consistency of service across developed, emerging, frontier, and next frontier markets thanks to the implementation of single common custody and asset servicing platforms.

“As these markets are moving through the stages of maturity, we also expect an increase in efficiency and product availability such as securities lending and short selling, e-voting solutions for proxy voting, along with reduction in settlement cycle and overall more real-time data flow,” says Harwood-Jones.

“Other considerations such as openness to foreign ownership, ease of capital inflows and outflows, foreign exchange (FX) liquidity, efficiency of operational framework, competitive landscape and stability of the institutional framework, along with solid corporate governance and investors transparency principles, can be more challenging.”

To be or not to be

Do such challenges mean that on occasion, a securities services provider will reluctantly have to forego the opportunity to open a new market? Harwood-Jones makes the point that, while major indices providers already have broad coverage of emerging and frontier markets, there are still many countries that do not yet qualify according to the criteria of economic development, market size, liquidity, and accessibility, despite having stock exchanges. “There would indeed be cases where we would not yet enter a given market,” she says. “This is due to factors such as smaller market cap, low liquidity, low volume, very little or nascent market infrastructure.

These markets would also pose higher risk of post trade inefficiencies”. Even with the benefit of scalable and highly market-adaptable custody platforms, she says, “The cost of entry can still be prohibitive against the business case and limited client demand, when considering the capital costs of setting up local branches or subsidiaries, together with onshore operations and infrastructure.”

For Harwood-Jones, there are instances where a local market and regulatory environment, “may not meet our strict internal standards in terms of asset safety protection, financial crime compliance, anti-money laundering, or ensuring that local regulations do not have unnecessary barriers for cross-border flows.”

As countries move through the stages of development, she suggests, “They would become more transparent and attractive to foreign investors and their service providers, such as Standard Chartered, who can share their expertise in international best practices via their thought leadership and advocacy activities.”

Engagement in a particular market may not be an all-or-nothing proposition. “Given the level of international regulations to protect the investor, if I’m not happy with a market infrastructure and capability to start active investor services, I may nevertheless establish some presence as I see things moving,” says Bruyns. “But I’ve also had demands for a market where I’ve said, ‘I can’t provide the desired level of service in this market for these reasons, so if you come into this market, there is a risk on you that you have to make sure is properly documented and contracted with your investors.”

“As a custodian, I don’t necessarily see the end-client,” says Bruyns. “I may not know if it’s a big private investor with a large portfolio who wants to be first into the market or if it’s an alternative investment fund or a pension fund, unless the bank tells me.

If they’re a long-term investor and all they want is custody and coupon collection on government securities, we may be able to provide that.”