Saudi Arabia catches the EM train

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Index provider FTSE Russell confirmed (see attachment) this evening that – as widely anticipated – Saudi Arabia has qualified for inclusion in to the FTSE Global Emerging Markets Index. Inclusion will take place in five tranches over March 2019 until December 2019. Saudi Arabia had been on FTSE Russell’s watch list since September 2015. FTSE Russell estimated that Saudi Arabia will have an index weight of 2.7% in EM on full inclusion (they also estimated that Saudi Aramco post-IPO could add an additional 1.35% to Saudi Arabia’s index weight, assuming a 5% freefloat and $1.5tn market capitalisation).

The plan is to stagger the inclusion over 5 tranches: 10% at the open on 18 March 2019, 15% at the open on 22 April 2019, 25% at the open on 24 June 2019, 25% at the open on 23 September 2019 and the remaining 25% at the open on 23 December 2019.

FTSE Russell announced that the following remain in their watch list, with no action taken: China-A shares (possible inclusion as Secondary Emerging Market); Romania (possible reclassification from Frontier to Secondary Emerging Market) and Iceland (possible inclusion as Frontier Market).

What does this mean for flows? The FTSE Russell Global Emerging Markets Index is mainly used by passive funds. We estimate that the index is tracked by $79bn of passive money (most notably the $68bn Vanguard ETF) but used as a benchmark by only by $843mn of active money. Applying a 2.7% weight to Saudi Arabia would suggest $2.1bn of passive flows (appx. 3 days trading for those stocks being added to the index, but split over five tranches) plus an insignificant $23mn of flows from active funds if/when they move to neutral – which might take some time. So in total, we calculate a potential $2.2bn of inflow to Saudi equities from passive and active funds resulting from FTSE Russell inclusion.

Much more important than FTSE Russell in terms of flows is MSCI. We would expect MSCI to follow FTSE Russell’s lead in mid-June,when the results of MSCI’s annual market classification review are announced. A successful review for Saudi Arabia would likely mean end-May 2019 inclusion into the MSCI Emerging Markets Index (unless the transition is fast-tracked). A phased addition is also possible. The MSCI Emerging Markets Index is tracked, we estimate, by $127bn of passive money and used as a benchmark by $449bn of active money. Using MSCI’s current provisional constituent list, Saudi Arabia would have a 2.4% weighting in MSCI Emerging Markets, which would suggest $3.0bn of passive flows (5 days trading for those stocks being added to the index) plus $10.8bn of flows from active funds (16 days trading) if/when they move to neutral – which might take some time. So in total, we calculate a potential $13.8bn of inflow from passive and active funds resulting from MSCI inclusion.

Simulated flows resulting from Saudi Arabia inclusion in to selected EM indices

Note: *days trading of those stocks entering the index

Source: EPFR, MSCI, FTSE Russell, Bloomberg, Renaissance Capital

As we have seen in the past (most notably in the cases of Qatar, UAE and Pakistan), countries being added to the MSCI emerging Markets Index have tended to outperform strongly in the run up to index inclusion. On average the outperformance has ended shortly after Index inclusion – see below graph which combines the last fifteen country additions to MSCI EM:

Average outperformance before and after inclusion in to MSCI EM, dollar-terms out(under)-performance vs MSCI EM

Source: MSCI, Bloomberg, Renaissance Capital

Conclusion: Good news for Saudi Arabia. FTSE Russell’s announcement makes us more confident that MSCI will make a similar announcement in mid-June on including Saudi Arabia in the MSCI Emerging Markets Index. FTSE Russell and MSCI between them could generate a total of $16bn of inflows in to Saudi equities, split $5bn from passive funds, $11bn from active funds (assuming active funds go to neutral Saudi Arabia over time). Markets have tended to perform strongly in the run up to inclusion in the MSCI Emerging Markets Index.