Emerging Market Fund Watch: MSCI Index Reclassification Doesn't Change Much (MSCI, VEIEX, VWO, EEM, DREGX, PRMSX, NEWFX)

In yesterday’s article about emerging market funds, we noted that three of the funds that track all or most of the stocks in the MSCI Emerging Markets Index could be affected by an upcoming review of the index by MSCI, Inc. (NYSE: MSCI).  Today MSCI has announced the results of its annual review and there is much less there than was anticipated.

The firm has postponed a reclassification of both South Korea and Taiwan as developed markets until its 2012 review. The decision means that the Vanguard Emerging Markets Stock Index (VEIEX), the Vanguard MSCI Emerging Markets ETF (NYSE: VWO), and the iShares MSCI Emerging Markets Index (NYSE: EEM) are unlikely to undergo a major revision this year. South Korea is the world’s 15th largest economy as measured by GDP and Taiwan is the 24th largest. Of course if China, Russia, India, and Brazil, all ranked in the top 12 are still considered emerging markets, then it makes some sense to leave South Korea and Taiwan among the group.

Both Taiwan and South Korea were held back by what MSCI terms “accessibility issues”  such as currency convertibility.

Other funds with significant exposure to emerging markets in Asia are Driehaus Emerging Markets Growth Fund (DREGX), where 36% of total assets of $857 million are held in emerging Asia markets. Larger funds are also heavily weighted toward emerging Asia. The T.Rowe Price Emerging Markets Stock Fund (PRMSX) holds nearly 34% of its total assets of $5.9 billion in emerging Asia, and the American Funds New World A fund (NEWFX) holds about 25% of its $22 billion in total assets in emerging Asia markets.

The top South Korean holding in all three of these funds is Samsung Electronics. Taiwanese companies don’t figure in as high or as consistently, with DREGX going for Taiwan Mobile, PRMSX going for Hon Hai Precision Ltd., and NEWFX opting for HTC Corp., as their top picks from Taiwan.

Another large fund we looked at yesterday, Oppenheimer Developing Markets A (ODMAX), currently has Taiwan’s HTC Corp., the leading maker of smartphones that use Google Inc.’s (NASDAQ:GOOG) Android operating system, at the top of its holdings. Samsung is the third largest holding of VEIEX and China’s largest mobile carrier, China Mobile Ltd., is the fund’s fourth largest holding.

One thing all these stocks have in common is their focus on technology and communications, where both South Korea and Taiwan are very strong. Taiwan Mobile is that country’s leading mobile phone carrier and Hon Hai makes iPhones and iPads for Apple Inc. Samsung Electronics is another large provider of Android-based smartphones.

The market for smartphones is exploding and expected to continue growing for some time. If South Korea and Taiwan were elevated to developed market status, almost all the high-performing stocks of smartphone manufacturers would disappear from the emerging market indexes and fund portfolios. And they wouldn’t be easy to replace with stocks of equal quality.

For now, though, MSCI has issued both the stocks and the portfolios a reprieve for at least another year. But some re-shuffling could occur between now and next June  when MSCI reviews its classifications again.

Paul Ausick