MSCI Declares Israel Is Now a Developed Market

Israel will be classified as a developed market, and no longer as an emerging one, as of May 2010, announced index compiler MSCI Barra late Monday night local time. The MSCI Israel Index will be now be included in the MSCI World Index, which includes most developed markets, and in the MSCI EAFE Index, which includes only Europe, Australasia and the Far East. Until now Israel has been classed in MSCI's emerging sector. Israel's emerging market status has meant that it constituted 2.8% of the Emerging Markets index and 13% of the MSCI EMEMEA index, which includes emerging markets in Europe, the Middle East and Africa.

Israel is expected to garner close to 0.4 percent of the World Index. Bank of America Merrill Lynch estimated Israel would rank 18th of the 24 developed market countries and have similar weightings to Denmark and Belgium, but higher than Portugal, Ireland, Greece, New Zealand and Norway.

Analysts believe outflows from emerging market funds would start soon while inflows from developed market funds will not appear until next May, when Israel joins the index.

"This could quickly create a significant downward pressure on the (blue-chip) index," said Gilad Alper, an analyst at the Excellence Nessuah brokerage in Tel Aviv.

The relatively short settlement cycle for equities on the Tel Aviv Stock Exchange was the only concern that was raised by international institutional investors during the consultation prior to the decision, the announcement said. MSCI noted that while this concern is important, it considers that it should not be an impediment to the reclassification of the Israeli market to developed markets status.

MSCI also called on the Israeli regulator and the Tel Aviv Stock Exchange to address the issues raised by investors who would prefer a better alignment with international practices.

With its reclassification, Israel will be dropped from the indices of Emerging Markets, and contribute a mere 0.38% to the World index. To date, an exchange traded fund investing $100 in an index that follows emerging markets has in fact invested $2.8 in Israel - or $13, if the fund invests in the EMEMEA index. These exchange traded funds will now be withdrawing their investment in the local market. In their stead, for every dollar invested in an exchange traded fund that follows the MSCI World, only $0.39 will be invested in Israel.

Merrill Lynch estimated that the reclassification will bring $2.8 billion into the local market through passive investments managed through ETFs over time. This seems like a tidy sum indeed, but Merrill Lynch goes on to explain that 75% of the money will be invested in just three stocks: 60% in Teva, or about $1.7 billion, and the rest in Israel Chemicals and Check Point Software Technologies. Teva is the world's largest generic drugmaker and Israel's biggest company. Israel Chemicals, Israel's second-largest listed company, would enjoy an additional $227 million investment. Disregarding Israel Chemicals for a moment, 67% of the $2.8 billion is expected to be invested in the two companies that are traded overseas, and in dollars. As a result, the Israeli capital market is unlikely to see much, if any, of this new money.

Psagot investment house says that while local conventional wisdom has it that the reclassification will not work in favor of the Israeli stock exchange, it expects the effect to be minor, citing a number of factors in support of its assessment. Foremost of these is the fact that the MSCI Israel index composite is weighted heavily in favor of a small number of companies. Teva, Check Point, Israel Chemicals, Leumi Bank and Bank Hapoalim together constitute some 70% of Israel's weight on the EM Index.

A substantial portion of the shares included in the index are heavily traded on stock exchanges in developed markets. Teva and Check Point, both world leaders in their respective sectors, are the subject of detailed analyst coverage, and as such are not expected to be adversely affected by Israel's upgrade by MSCI.

Any negative effect leading to reduced investments in Israeli shares, Psagot argues, will be very limited. They would be felt primarily in equities of companies that do not maintain broad global activity, such as Bank Leumi and Hapoalim. But these two, together with other equities, constitute 40% of the companies included in the EM Index.

Another argument in support of the forecast that the new classification will result in only limited negative effect is based on the low percentage - about 10% - of foreign investors in the Tel Aviv Stock Exchange.

Tel Aviv's main share indices have bounced back about 30% so far in 2009 after a 50% plunge in 2008 on the heels of the global financial crisis.

Daily turnover is still below the 2008 average of $547 million, at around $400 million. Israeli institutions account for 70% of trading volume, with foreign investors comprising 20%. "The biggest risk is that developed market investors ignore Israel, or perhaps more likely only look at the largest MSCI names," UBS analyst Darren Shaw wrote in a note to clients. Shaw said that with share prices likely to drop in the short term, "this could offer selective buying opportunities."