W.HAS DOES Saudi Arabia, with a per capita income of $ 23,000, lavish public services and vast amounts of oil, has in common with Zambia, where incomes are 94% lower and the government is on the verge of default. Not much at first glance. In JPMorgan Chase’s definition of “emerging markets”, the two countries are combined with 71 other countries.
Index providers set the metrics that passive funds track and active managers use as a benchmark. Those like JPMorgan, which benchmark emerging market bonds, are particularly strong. You exert influence over an asset class valued at $ 30 billion, about a quarter of the global fixed income. For borrowers, the inclusion of benchmarks opens the door to foreign capital. Inclusion of Chinese onshore debt in three major benchmarks this year and next is expected to raise $ 450 billion in foreign money. For investors, index changes can force them to revise their portfolios by selling holdings to make way for new debt. “Indices have an almost tyrannical influence,” says Jan Dehn of the Ashmore Group, a fund manager.
The main providers include Bloomberg, FTSE Russell and JPMorgan. The first two are global bond indices that span emerging markets. JPMorgan dominates the market for dedicated emerging market investors. Around USD 780 billion corresponds to the benchmarks introduced in the 1990s. It is one of the few banks that is still in business. Morgan Stanley, another bank, was discharged MSCI, its index unit, over a decade ago. Others, including Bank of America, Barclays, and Citigroup, have also sold theirs. The industry has tried to reduce the regulatory risk following the interest rate rigging scandal surrounding the London Interbank Offered Rate (LIBOR).
Classifying a country as an emerging market requires a high level of subjectivity – for example, more than is necessary to determine which companies should be included in a country’s benchmark index. To be representative and predictable, vendors publish chunky rulebooks to help investors understand which bonds might be added or ejected. They also urge investors to find out which bonds are liquid, accessible, or otherwise suitable for inclusion. Still, the rules can sometimes be applied in seemingly arbitrary ways. To see this, you should consider the recent big adjustments to the JPMorgan benchmarks that have caused investors to realign their portfolios.
In 2019, the bank added the Gulf states to its hard currency index for government bonds after the 2014 oil price crash led to a rush of issues. Places like Saudi Arabia and Qatar were too rich to qualify, but the bank adjusted its rules to accommodate them. It also cut the weight of the defaulted Venezuelan government bonds to 0% over the past year instead of removing them altogether. This unprecedented move saved some bondholders from having to offload the debt that is under US sanctions.
In February of this year, JPMorgan began adding a selection of debt issued by the Chinese government and its political banks to its local bond benchmark. With China ultimately accounting for 10% of the bank’s main benchmark, it is risky for investors not to stay invested. But some say the decision was rushed. They cite a long list of operational issues when trading debt securities, including poor liquidity and complications in processing transactions. Last month FTSE Russell said he will also add local Chinese bonds to his government bond index from October 2021 – pending reforms that make it easier for foreigners to trade debt.
JPMorgan’s customers include both issuers and investors who may be a source of conflict. Other parts of the bank operate in emerging markets. (JPMorgan says there are Chinese walls to separate its businesses.) Months after the index group announced it was adding government debt to its benchmarks, the company won valuable deals to raise funds for mammoth Saudi Arabian oil company Aramco to collect. The bank has other interests in the Chinese bond market as well. It writes government bonds and is the official market maker at Bond Connect, a trading platform that allows foreigners to invest via Hong Kong.
Another problem is that some customers are heard more than others. “It’s hard to avoid having index providers addressing the needs or wants of their larger customers,” says Paul McNamara of GAM, an investment manager. Bloomberg and FTSE Russell regularly arranges round tables for customer groups. Some investors are not afraid to give their opinion to the providers. Hayden Briscoe of UBS Asset Management recalls that the person in charge of one of the popular bond indices included the Chinese debt three years ago. “The faster you add the bonds to the index, the faster you become a rock star,” he advised.
JPMorgan downgraded its advisory committees in 2015 in favor of one-on-one meetings to reach a broader group of investors. It is said that the aim is to keep the playing field the same so that no one gets a plan early on and leads the market. Still, small fund managers suspect that their larger competitors have the ear and lobby of the index team to include assets they own.
Disgruntled investors, however, cannot easily move away from established indices. The barriers to entry are high. To build a benchmark, a lot of money has to be spent on marketing to build a trustworthy brand. There are still few signs of newcomers. A network effect encourages fund managers to use the same yardstick so clients can compare performance. Switching indexes requires a lot of paperwork to keep customers informed. As a result, even though JPMorgan has made an ex-China version of its main meter, interest has been low. Investors will adopt the rules for some time to come. ■
This article appeared in the Finance & Economics section of the print edition under the heading “The Rule Setters”.