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Passive is active: the EM index problem

The Emerging View

11 July 2017

In a recent article about China’s inclusion in the MSCI benchmark index the Financial Times columnist John Authers made the following astute observation: “There is something ungainly in the way [China’s index inclusion] has been outsourced to MSCI, a relatively small for-profit organisation based in New York. Such a momentous matter… might seem more naturally to belong to democratic or governmental institutions. As it is, the big multilateral organisations do not seem to be providing …leadership.“1 What makes Authers’ observation interesting is not just that he recognises the enormous problem of poor index representation for Emerging Markets (EM) assets, but also that he explicitly links this problem – a classic market failure – to international financial institutions (IFIs). Index provision is a public good, which is why current provision by the market is grossly inadequate. The costs to the financial system of poor index provision include lower returns, excessive volatility and insufficient diversification. One particularly quirky consequence of the inadequate index provision is that investors, who believe they are taking passive exposure to EM by closely tracking the main benchmark indices, are in fact taking very active bets, since the index-providers filter nine out of ten bonds in the EM universe from the indices. Ashmore has raised the EM index problem in previous publications.2 This report provides an update on the scale of the problem with specific reference to EM fixed income markets, outlining the associated costs and proposing ways to resolve the problem with an explicit call on IFIs to take this problem seriously.

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