What do changes like this mean for investors? When country-classification events change the sector and regional makeup of an index's exposure, the drivers of risk and performance in that market can shift significantly. Regulatory and operational nuances exist in these markets, and experience navigating within them is crucial, as there can be significant delays and penalties for not understanding them. Investors caught unprepared may end up buying at the very top of the market, as country promotions can cause large liquidity events.

It's crucial to prepare well in advance of the effective promotion date. Corporate and institutional investors must carefully plan how they will enter markets that are newly deemed "emerging." At the moment, that means closely watching movements around China A-shares and Saudi Arabia.

Where Will China A-Shares Go?  

Historically, most indices have achieved exposure to Chinese equities through Hong Kong-listed securities. (See Figure 1, on page 2.) That's because investors outside of Mainland China have had limited access to China A-shares, securities that are incorporated in China and listed on the Shanghai or Shenzhen Stock Exchange. Currently, investors outside of China access Chinese equities predominantly through the H-shares listed on the Hong Kong Stock Exchange and American Depository Receipts (ADRs) listed on the U.S. exchanges. MSCI recently added a subset of ADRs to its Emerging Markets Index. These ADRs now comprise approximately 2.8 percentage points of the index's nearly 25 percent that is allotted to China; Alibaba and Baidu make up a majority of that weighting, at a combined 1.8 percentage points.

Many index providers, such as MSCI, offer China A-shares securities as a standalone index for investors who have access. Large institutional investors that meet certain operational and assets-under-management (AUM) requirements can invest through the Qualified Foreign Institutional Investor (QFII) platform. The other potential channel for U.S. investors is the Hong Kong Stock Connect, which was created to enhance liquidity, broaden the investor base, and help promote the internationalization of the Mainland China capital market. Each channel has a quota—i.e., a maximum amount of assets that foreign investors can trade in a given time frame. The Hong Kong Stock Connect quota applies to the overall market rather than to individual investors, while the QFII program allocates a specific quota to each institutional investor.

In March 2014, MSCI launched a consultation around the potential inclusion of China A-shares in the global opportunity set. As the nation's market structure and barriers to investing continue to improve, China A-shares are projected to join the MSCI Emerging Markets Index. However, given the size of institutional assets under management, and the risk of limited capacity for large asset managers under the existing quota system, the quotas remain worrisome. Additionally, the Hong Kong Stock Connect has daily trading limits. Together, these factors create uncertainty around liquidity, especially in relation to index managers that will target the local market close. These challenges mean that index funds may not be able to achieve the local closing prices of the securities markets to which they are benchmarked.

We expect China A-shares to eventually make up nearly 20 percent of the MSCI Emerging Markets Index, which would increase the index's overall China exposure to almost 40 percent. This could potentially present a large country bias in the index, as well as an increase in regional exposure to Asia-Pacific countries to as much as 75 percent of the Emerging Markets Index. In the near-term, though, MSCI expects to apply a 5 percent inclusion factor initially. The inclusion factor is utilized to reduce the weight of China A-shares given the ongoing concerns around accessibility. This would mean the China A-shares would receive a lower weighting within the MSCI Emerging Markets Index—approximately 1.2 percent by our estimates. Upon further market structural developments, MSCI may gradually increase the inclusion of China A-shares.

Discussions about the proposed inclusion factor continue. Chinese authorities have recently implemented changes that enhance accessibility to China A-shares; the changes center around the quotas, capital mobility, and beneficial ownership concerns for asset owners delegating investment and operational decisions in the local market. Specifically, quota allocations in the QFII platform may be linked to investor size. MSCI is also seeking feedback from investors on voluntary market trading suspensions, which seem to have been alleviated earlier this year, and limitations on hedging vehicles for institutional investors outside Mainland China.

MSCI will soon make a decision about whether to include China A-shares in its Emerging Markets Index. If it does, this change may present a new investment landscape for investors, requiring investment and operational expertise for China A-share investing.

Saudi Arabia: An Emerging Presence

Like the China A-shares, the securities market in Saudi Arabia has the potential to enter mainstream emerging-market indices. Saudi Arabia has historically limited access to securities traded in its country and has allowed only the states in the Gulf Cooperation Council (GCC) to invest. Thus, Saudi Arabia is currently a standalone index. (See Figure 2, below.)

Over the past few decades, Saudi Arabia has evolved from a desert kingdom to a contemporary nation-state, largely through development of its energy reserves. The country has smaller equity markets and is less populous than China, but relative to other emerging markets, it is large in terms of both its economy and market size. The MSCI Saudi Arabia large and midcap index market capitalization is US$115.1 billion. The country has a GDP of $746.2 billion and a population of 30.9 million. If the country were to relax restrictions on investing, Saudi Arabia would likely graduate to the emerging-market indices and further impact the global investing landscape.

Saudi Arabia is also home to one of the largest private energy companies in the world, Saudi Aramco, which is owned by the government. The nation's deputy crown prince recently mentioned publicly that the company might be a candidate for a partial listing on the local Tadawul stock exchange (the Saudi Stock Exchange, SSE). Market speculation estimates the market capitalization of Saudi Aramco at $10.5 trillion on the high end. That estimate dwarfs the largest U.S. petroleum and petrochemicals business ExxonMobil, valued at $325 billion. Some believe that even a partial listing is unlikely, as it would open doors to information held closely by the state and leave the company vulnerable to competition. But if a listing did happen, it would help bolster foreign investment and further the development of the Tadawul.

If Saudi Aramco were to have an initial public offering (IPO), foreign investors might not have the opportunity to participate. Today, Saudi IPOs are limited to local investors. The prince calmed speculation on April 1, 2016, when he announced that the kingdom would sell a stake of less than 5 percent in the parent company, not its subsidiaries, sometime next year or in 2018.

Regardless of what happens with Saudi Aramco, this is a market to watch. In recent years, there have been discussions about whether Saudi Arabia would progress from a standalone index and enter the broader "frontier markets" universe, or would graduate directly to the "emerging markets" space. If the country takes the latter path, we project that Saudi Arabian securities would be included in the MSCI Emerging Markets Index at a weighting of 0.5 percent. If the country's market removed foreign inclusion limits, the weighting would increase dramatically, to a projected 2.6 percent. And if 5 percent of Saudi Aramco were to be publicly traded, the country would get closer to a 3.5 percent weighting in the index (assuming a $10.5 trillion market cap), even with foreign inclusion limits in place.

However, for Saudi securities to graduate into the emerging-markets category, the kingdom must address outstanding concerns around the Tadawul, including investability, operational barriers, market structure, voting rights, counterparty participation in the market, custody, and clearing/settlement processes. Saudi Arabia's equity market is still relatively new, but the evolution of its market structure and foreign investments has heightened index providers' attention around potential inclusion in the global indices.

A Thoughtful Approach for Potential Implementation

If China A-shares or Saudi Arabian equities do get called up to join the emerging-market indices, this change could have a significant impact on global securities markets. Whenever a major index moves a country from the frontier markets or a standalone classification to "emerging," the move causes a graduation effect on liquidity as that market matures. The large pools of assets allocated to these indices are suddenly required to purchase securities in these markets, which can generate significant market impact. 

Figure 3, below, shows how drastic these large liquidity events can be. Investors saw the United Arab Emirates (UAE) and Qatar graduate to the MSCI Emerging Markets Index, effective in the May 2014 semi-annual index review. Trading volume in these nations spiked on the effective date of the promotion—for Qatar to nearly 10 times the average daily volume over the previous 12 months, and for UAE to nearly 4 times the average. Performance lead-up from the announcement date of the UAE and Qatar promotions to the effective date was also impactful.

It's crucial for investors to understand how the graduation of the securities may change the sector and overall risk profile of the broader index. Given the performance of UAE and Qatar from the date of the MSCI announcement to the effective date of the promotion, it seems likely that the most proactive investors were purchasing these countries' securities in advance of the effective date, leaving less-prepared investors to purchase at all-time highs in the two markets.

Over $100 billion is estimated to be benchmarked to MSCI Emerging Markets. That means if China A-shares and Saudi Arabia were promoted to "emerging markets" status, that decision would translate to purchases of $1.2 billion in China A-shares and $500 million in Saudi Arabian securities at our weighting estimates of 1.2 percent and 0.5 percent, respectively. Investors that want to participate should be aware that regulatory structures regarding initial investment in these markets may prove challenging and time-consuming, and may require attention far in advance of implementation and initial purchase.

Investors who followed the MSCI Emerging Markets Index into UAE and Qatari securities needed to take several actions in advance. For one thing, both markets required opening through the investor's custodian for equity and foreign exchange trading. This wasn't a complex task for investors looking to enter UAE or Qatar, but other markets take long periods of time to open. Some markets maintain a stringent process for opening, requiring registration paperwork, legal and/or regulatory processes, and sometimes investors' specific identification documentation. For example, Vietnam and India can take up to a year. Therefore, it's important for investors to initiate the opening process immediately after the announcement of the effective date of a country's graduation to emerging-market status.

As Saudi securities and China A-shares knock on the door of the major emerging-market indices, the time is right for global investors to begin researching the requirements around opening these markets and making equity investments in China and Saudi Arabia. Investors in UAE and Qatar would have benefited from a thoughtful approach to implementation prior to the effective promotion date.

Likewise, investors that don't want to be caught in the potentially massive graduation effect around China A-shares or Saudi Arabia's possible promotion are now planning their approach. It makes a lot of sense to get ahead of these large liquidity events, both operationally and economically.

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Greg Behar joined LGIMA in 2015 as Head of Index Strategy, where he is responsible for providing investment thought leadership to investors and is responsible for developing comprehensive investment solutions and insights across the spectrum of index strategies. Prior to joining LGIMA, Greg was a Senior Vice President and Head of Global Equity Investment Strategy at Northern Trust Asset Management. Greg holds a B.A. in economics from Binghamton University and serves on various index advisory panels.  

Joe LaPorta joined LGIMA in July 2015 as an Index Trader. Prior to joining LGIMA, he worked at Northern Trust Asset Management as  Second Vice President, Portfolio Manager, where he was responsible for managing international equity index commingled products, separately managed accounts, and ETFs benchmarked to developed, emerging, and frontier markets.  Joe holds his BBA in Finance from The University of Iowa.

Views and opinions expressed herein are as of March 2016 and may change based on market and other conditions.The material contained here is confidential and intended for the person to whom it has been delivered and may not be reproduced or distributed. The material is for informational purposes only and is not intended as a solicitation to buy or sell any securities or other financial instrument or to provide any investment advice or service. Legal & General Investment Management America, Inc. does not guarantee the timeliness, sequence, accuracy or completeness of information included. Past performance should not be taken as an indication or guarantee of future performance and no representation, express or implied, is made regarding future performance.