Saudi Arabia’s inclusion in emerging markets is happening. As part of the Annual Market Classification Review announcement, MSCI announced that it would include the MSCI Saudi Arabia Index in the MSCI Emerging Markets Index, the MSCI ACWI Index and other global and regional MSCI indexes, starting in June 2019. What is the potential impact of this reclassification for emerging market investors?
Improved market access
The decision to include Saudi Arabia in the MSCI Emerging Markets Index was taken in consultation with international institutional investors. It followed a number of regulatory and operational enhancements in the Saudi Arabian equity market that effectively improved market access for such investors.1
Saudi Arabia’s inclusion in the emerging markets index may provide expansion of the investment opportunity set and potential diversification benefits. These include the market’s historically high yield, its distinct sector composition, low sensitivity to other emerging markets and its potential natural currency hedge.
Implementation – a two-step process
On a pro forma basis, the MSCI Saudi Arabia IMI will represent approximately 2.6% of the MSCI Emerging Markets IMI (which includes small-cap stocks) and will add 69 securities. There will be a two-step inclusion process, occurring in May and August. With this inclusion, Saudi Arabia is likely to represent the ninth-largest weight in the index, on a pro-forma basis.
Saudi Arabia’ weight in provisional MSCI Emerging Markets IMI index
As of Dec. 31, 2018
Saudi Arabia’s Historic High Dividend Yields
Saudi Arabian equities historically has offered above-average dividend yields. Following the global financial crisis, central banks around the world tried to stabilize their respective economies by cutting their primary interest rates. In effect, these central bank actions made bond yields appear relatively less attractive, with many institutional and retail investors seeking exposure to high dividend-paying equities as a way of meeting their income needs. Over the last four years, Saudi Arabia’s yield has exceeded the emerging markets’ yield by 140 basis points, on average (see exhibit below).
Saudi Arabian equity yields have surpassed emerging markets as a whole
Distinct Sector Composition
In addition, Saudi Arabia’s distinct sector composition has shown diversification benefits. Financials and materials comprise more 75% of the IMI Index, providing much higher exposures than the MSCI Emerging Markets IMI. Information technology, which is generally one of the biggest sectors globally, had no representation in Saudi Arabia, while industrials and healthcare had relatively low exposures as well, as we can see in the exhibit below.
Saudi Arabia’s current sector exposures
As of Dec. 31, 2018
This distinct sector composition contributed to Saudi Arabian equities’ low correlation to other emerging markets, exhibiting low-to-negative correlation on a 1-year rolling basis (the correlation has increased more recently).
A potential natural currency hedge?
While investing globally has historically has yielded diversification benefits in terms of asset allocation, it also means investors are exposed to currency risk. Our analysis shows that since May 1994, the MSCI Emerging Markets IMI returned 7.8% on an annualized basis, in local currency terms. The USD returns were substantially lower at 4.8%. While this shortfall is hypothetical, as it is difficult to secure the local currency returns in each emerging market country without bearing a hedging cost, it illustrates how currency depreciation has affected emerging-market investors.
As the Saudi riyal is pegged to the U.S. dollar, U.S. dollar investors are unaffected by the riyal’s fluctuations with other currencies. While U.S. dollar appreciation impaired emerging markets in 2018, Saudi Arabia outperformed emerging markets as a whole. Currency was one of the main contributors to Saudi Arabia’s significant outperformance in 2018, adding 4.3% to performance. Since August 2014, the currency factor has contributed 2.6% on an annualized basis.
Saudi Arabia has often outperformed during EM currency stress
The inclusion of Saudi Arabia may trigger important investment questions, such as whether systematic factor strategies have worked well in Saudi Arabia and what are the implications of including Saudi Arabia mean for ESG investors. Investors will likely be seeking answers to these questions.
The author thanks Raman Aylur Subramanian for his contributions to this post.