Musical chairs for indexes?

Analysis |

A top global index provider said last month it may reclassify South Korea and Israel as "developed" instead of "emerging" economies, a move some say could reduce foreign investment in those countries.

Both are now listed as emerging economies by MSCI Barra, whose indexes are tracked by index funds and exchange-traded funds and commonly used as performance benchmarks for active funds.

If the markets were listed as "developed," they might find themselves small fish in big ponds, says David Riedel, president of Riedel Research, a research firm.

South Korea, for instance, is now among the largest of the 20 countries in the MSCI emerging-markets index, according to Morningstar. If it becomes part of the developed market MSCI EAFE (Europe, Australasia, Far East) index, which excludes the United States and Canada, it would be dwarfed by the United Kingdom and Japan, each comprising 21 percent of the index.

Funds tracking the emerging-market index would have to sell holdings in South Korea and Israel while ones tracking EAFE would add them. Yet active funds might limit investments in a nation such as South Korea due to its small size relative to other developed markets, Reidel says.

Morningstar analyst Bill Rocco says the perception of a country might not change despite a new classification. "It's not like people are going to look at Israeli companies differently than they did before," he says.

The term "emerging markets" was coined by economist Antoine van Agtmael in the early 1980s. In general, if the World Bank lists a country's economy as anything other than "high-income," many experts consider it "emerging," says Christian Deseglise, HSBC Investments' global head of emerging markets.

In other changes, MSCI Barra says it may downgrade Colombia and Argentina to "frontier" from emerging markets, and that Kuwait, Qatar and the United Arab Emirates may be upgraded to emerging markets. A decision is expected by June 2009.