As large sums of global money flows now follow global indices, it is important to understand how global index providers decide on country classifications and country weightages. A global equity index typically has two components, a developed market index and an emerging market index. Until the nineties, emerging market investments were not necessarily mandatory for all large institutional investors but that changed more than a decade ago and global investment portfolios are the norm now. What has also changed is that earlier markets were classified on the basis of their GDP per capita, size of the stock market and accessibility criteria, since most of these parameters were in sync with each other.
However, given the growing size of global fund flows and growth of emerging markets, a number of criteria are now reviewed. This can include the presence of a strong regulatory authority, ease of repatriation of funds, custody, clearing and settlement infrastructure, transparency in decision making, liquidity, and transaction costs. While index providers provide the criteria for classification, the actual decision making will devolve on large market consultations. In an annual or bi-annual exercise, market participants, including asset managers, traders, and asset owners, are polled in their views for each of the criteria for the markets. Based on the feedback received, markets will be classified as developed, emerging and frontier. The weight of the market within the index is derived from the float adjusted market capitalization of the market. This means that the sum of each of the stocks included in the market by their float market capitalization gives each market its weight in the index. Countries that have restrictions on foreign investors in the form of a percent limit will get that limit applied to the market capitalization to give a clear picture of what is actually available to foreign investors. In recent time, this issue has been muddied considerably by the multiplicity of restrictions and access provided by a market like China,where it is hard to pin down a single number.
Earlier, we spoke of frontier markets, a category where the markets are typically very small or accessible in a very limited way. Markets like Ghana, Tunisia, Bangladesh and Sri Lanka fall in this category. Graduating markets from frontier to emerging and emerging to developed can cause a big change in the fund flows to a country. While a move from frontier to emerging is welcomed across board, the story can be different for a move from emerging to developed status. Israel had an approximate 3% weight in an emerging market index a few years ago. When it was graduated in 2010, it fell to only 0.4% of a developed market index. This kind of a move can actually cause fund flows to considerably dry up for a market.