Investing in the Presence of Massive Flows: The Case of MSCI Country Reclassifications

Abstract

Almost $10 trillion is benchmarked to MSCI’s developed, emerging, frontier, and standalone market indexes. Reclassifications from one index to another require thousands of investors to decide how to react. We study a comprehensive sample of past reclassifications to inform this decision. On average, reclassified markets’ prices substantially overshoot between the announcement date and the effective date—prices fall when a market moves from an index with more benchmarked ownership to one with less (such as from emerging to frontier) and vice versa—but largely revert within a year. We identify alpha-maximizing responses to reclassifications for both benchmarked and more flexible investors.

Disclosure: The views expressed herein are those of the authors and do not necessarily reflect the views of the National Bureau of Economic Research or Acadian Asset Management. The views expressed herein should not be considered investment advice and do not constitute or form part of any offer to issue or sell, or any solicitation of an offer to subscribe or to purchase, shares, units, or other interests in any particular investments.

Editor’s Note

This article was externally reviewed using our double-blind peer-review process. When the article was accepted for publication, the authors thanked the reviewers in their acknowledgments. Andrew L. Berkin and Joanne M. Hill were the reviewers for this article.

Submitted 17 January 2017

Accepted 20 August 2017 by Stephen J. Brown

Acknowledgment

We thank Andrew L. Berkin, Brendan Bradley, Executive Editor Stephen J. Brown, Joanne M. Hill, Asha Mehta, CFA, and seminar participants at Acadian Asset Management, the University of Cambridge, the University of Oxford, and the University of Warwick for many helpful comments. We are also very grateful to MSCI for providing data on the extent of indexation.

Notes

¹ MSCI Inc. was formerly known as Morgan Stanley Capital International and MSCI Barra.

² Openness criteria include investor qualification requirements, foreign ownership limits, foreign room levels, and the rights of foreign versus domestic investors. Ease-of-flows criteria include capital flow restrictions and degree of currency market liberalization. Operational framework criteria include registration and account setup difficulty, market regulations, information flow, clearing and settlement, custody, registry/depository considerations, trade execution, transferability, stock lending, and short selling. Also considered are the degree of competition among financial service providers and the stability of the institutional framework. There is an additional requirement concerning gross national income per capita to qualify for “developed” status. See MSCI (2016b).

³ We exclude the 2008 reclassifications of Serbia and Lithuania. MSCI conditioned its final decision on those two reclassifications on aspects of market performance between the announcement date and the potential effective date, making it unclear what, if anything, investors should be doing in the meantime. We also exclude the markets included at the inception of the frontier index, introduced in 2007, because the announcement and effective dates were nearly contemporaneous and, presumably, the flows associated with those classifications would be small.