June 30, 2012

MSCI last week conducted its annual market classification review of the countries in each of its indices. MSCI, which stands for “Morgan Stanley Capital International,” determines the member countries of the EAFE “Europe, Australasia, Far East” index, on which the TSP’s I Fund is based. Therefore any changes it decides to make to its indices can have a direct impact on TSP participants’ I Fund investment.

While MSCI did not change the composition of the EAFE index this year, it suggested that a few changes might come in the next few years. It first announced that it was adding Greece to “the review list for potential reclassification to Emerging Market” status. This is no surprise, of course, given the severe economic crisis and long-term structural issues in Greece. Greece is already a very minor part of the index, with I Fund holdings of Greek companies amounting to only 0.2% of the fund. Dumping them from the index would therefore not have a discernable impact.

MSCI said as much when it stated that Greece will be added to the review list “because it no longer meets Developed Markets size standards with only two eligible index constitutents and because the Greek authorities have failed over the last several years to bring equity market regulations and practices in line with the evolving standards of Developed Markets.”

MSCI also announced that South Korea will remain a developing market, so it will not join the I Fund just yet. MSCI made this decision primarily because South Korean authorities maintain “limitations in currency trading and equity settlement across multiple accounts,” which can hinder trading by large institutional investors such as BlackRock, the manager of the I Fund.

MSCI noted a similar issue with Taiwan, which otherwise “meets many Developed Markets criteria, including economic development and market size and liquidity.”

Of course, there is also the unstated issue of geography, since they both border countries that do not recognize their right to exist as sovereign states. Eighteen months ago, for example, North Korea fired artillery at South Korean islands, destroying dozens of homes.

If they are ever added to the MSCI EAFE index, they would make a significant contribution to the index. Currently as members of the MSCI Emerging Markets index, Korea and Taiwan are the second and fourth largest holdings respectively, after China and Brazil. Samsung and Taiwan Semiconductor Manufacturing are the largest and third-largest single-company holdings in the index. As long-time TSP participants know, I Fund investors cannot currently invest in developing countries through their TSP holdings, nor strangely enough can they invest in Canada as part of the I Fund.

Related topics: i-fund