Emerging Market Indexing

Let’s say you want to build your own stock market index fund based on the S&P 500. Easy: download a list of all the companies in the index (from 3M to Zions Bancorp) and their market cap, and start investing. Every stock in the index will be easy to buy in whatever quantity you want.

Now, after the success of your first index fund, you decide to create an emerging market fund, concentrating on the world’s up-and-coming economies. Again, no problem. We have the internet, after all, and we can just print off a list of all the stocks in China, India, Chile, Hungary, and so on, pull out a pile of Benjamins, and go to town.

That won’t work, says Raman Subramanian, Executive Director of Index Research at MSCI. Subramanian oversees the index underlying the the two largest emerging markets: ETFs, from Vanguard (VWO) and iShares (EEM). “You can go to any of the emerging markets and download the listed stocks there,” says Subramian. “But there can be some potential issues.”

So how do you build an emerging markets index, anyway? And, can it shed any light on how you should invest your money?

Who’s emerging?

The first order of business for Subramanian, or any emerging markets indexer, is to decide which countries count as emerging markets. This is not as easy as it sounds: no two indexes agree on which countries are emerging.

MSCI uses three criteria to classify a country as developed, emerging, or frontier (“frontier” is an euphemism for “not really emerging yet”).

Wealth. A country has to have a GDP per capita above a certain threshold to be considered developed; below that, it’s emerging or frontier.

Market structure. In order to be included in the index, a country has to have an active stock market with many companies listed and few or no limits on foreign ownership.

Accessibility. How easy is it to participate in country’s market? “If you’re a US investor and want to invest in India, how do you go about setting up that account?” says Subramanian. “What are the regulations?” To determine market accessibility, MSCI surveys market participants about their experience.

A wealthy country with market structure or accessibility issues might be classified as “emerging.” MSCI puts Taiwan and South Korea in this category. (They redo the list annually.)

Pick of the list

Now that we have a list of economies to put on our index, we just go out and buy all the stocks, and…. Wait, that won’t work, either, because some stocks are hard to buy. They might be stocks of very small companies or companies closely held by a small number of shareholders, with few shares trading freely. If you include those stocks in your index, it makes it harder to invest in the entire index and drives up the cost of trying.

So MSCI excludes companies that it considers insufficiently “investable.” To be investable, your stock has to trade on at least 4 out of 5 days, and at least 15% of the stock has to trade freely, not be held by controlling interests or otherwise out of circulation.

How much are investors in VWO or EEM missing out on by not owning these companies? Not much. The MSCI index captures almost 98% of the total market cap of the listed countries. “What is excluded is basically very small companies, illiquid companies,” says Subramanian.

In short, emerging markets indexes aren’t easy to build, but they’re constructed on a simple principle: own the most liquid securities in the most accessible markets.

How to beat the index

I became interested in this question of how to build an emerging market index because (a) I am a huge nerd, and (b) recently I interviewed an investment guru who argued that there is great opportunity for active managers to outperform in emerging markets because the markets are inefficient.

That argument doesn’t hold up, because, as I explained, the record of active managers in emerging markets is the same as it is everywhere else: ludicrously bad. Most managers underperform the index; the ones who outperform are an annually rotating cast whose good fortune is mostly indistinguishable from luck.

But learning how the MSCI index is constructed gave me a new idea: couldn’t I start an active fund specializing in those unloved securities that MSCI and the other indexes won’t touch? Small companies, illiquid stocks, frontier markets. Sure, they’re risky. That’s the point: you have to take risks to get higher returns.

Bad idea, says Larry Swedroe, director of research at Buckingham Asset Management and author of the Wise Investing series. “The more inefficient the market is, the higher the trading costs are,” says Swedroe, who has written frequently about active management in emerging markets. “The round-trip in emerging markets is extremely expensive.”

In other words, to pull off my trick, I have to outperform by a margin big enough to cover my costs—the curse of every active manager. Vanguard’s ETF, VWO, charges an expense ratio of 0.2%. I don’t even want to think about what my expenses would be.

Subramanian agrees. “Sometimes active managers will try to capture that illiquidity premium by going into those stocks,” he says. “But then the question becomes, can they sell it?” The big problem is market impact: if my illiquid stocks do well and I try to sell them, I’ll depress the market price, causing a hefty chunk of my gains to vanish.

As for those frontier markets, Swedroe steers clear. “The reason they’re called frontier markets is because generally they don’t have the rule of law and international investors are not well protected,” he says. “If those things are not present, you shouldn’t invest no matter what the risk premium is.”

The bottom line

Costs matter in investing: they compound just as surely as gains, and for this reason, low cost is an excellent predictor of above-average mutual fund performance. If you want to invest in emerging markets, there is no way to do so at low cost other than by using an index fund (or, to be scrupulous, a passive index-like fund such as those from Dimensional Fund Advisors).

Vanguard’s ETF, remember, charges 0.2% annually. Its actively managed competitors tend to charge between 1.5% and 2%. This, more than any arcane argument about market efficiency, is why indexing works in emerging markets: it doesn’t involve throwing away 1.5% of your money every year in pursuit of elusive market-beating strategies.

Matthew Amster-Burton is a personal finance columnist at Mint.com. Find him on Twitter @Mint_Mamster.