Israeli capital market players are looking to February with bated breath, in hopes that the results of a survey of global investors will lead to Israeli stocks being added to a key regional index benchmark, a move that could add at least $1 billion in investments into Israeli equities, according to some estimates.
MSCI Inc., a US financial firm that is a global provider of equity, fixed income and equity indexes for investors to track with the funds they manage, said in December it has started a poll among international investors to see how they perceive their investment opportunity in Israel: Do they still see Israel as part of a Middle East investment opportunity or should the nation be reclassified, in terms of its index, elsewhere – for example in Europe, or Asia? Investors have until the end of the month to provide their survey feedback, and the results of the consultation will be published on or before February 28.
If the reclassification is approved, and Israel is added to the MSCI Europe Index, as hoped, the implications for the Israeli capital market would be “hugely significant,” said an analyst at an investment bank.
“Including Israel in MSCI’s Europe Index family would likely yield several billions of dollars in investment into Israeli equities listed worldwide,” said Steven Schoenfeld, a veteran of the investment management industry and CEO of MV Index Solutions, which develops, monitors and markets a selection of benchmark indexes.
“It would also probably lead to even greater long-term capital flows, as Israel would gain a meaningful weight in several widely-followed MSCI indexes that are the benchmarks” for both passive and actively managed funds, with aggregate assets approaching one trillion dollars, Schoenfeld added.
The big picture
Let’s take a step back.
MSCI is a developer of indexes that are tracked by financial assets worldwide. An index is a collection of stocks that moves according to the shares held within it, and stock indexes are very popular trading vehicles as investors don’t need to investigate each and every stock, but rather just choose the index — an index with technology stocks or emerging market stocks, say — and pour their money into products that track the index. This money then gets distributed among the shares within the index according to the share-weighting on the index.
The indexes of MSCI are very popular with investors and fund managers, with some $16.3 trillion in assets under management benchmarked to MSCI indexes as of the end of June 2021 and more than 1,300 equity exchange traded funds based on MSCI indexes, as of March 31, 2020, according to the MSCI website.
MSCI clients are financial asset managers who create products that track the indices, and investors buy into these products.
Trading in products that precisely track indexes is called passive investment, as money flows into the stocks within the index without actively being chosen by investors, and the funds get allocated to the stocks within the index, according to their weight in the gauge. Active investors who specifically choose what stocks to invest in also use these indexes as a benchmark, and the investment scope of their fund is often limited to shares that are included in one or another index.
In 2010, with great fanfare, Israel joined the Organization for Economic Co-operation and Development (OECD), the elite club of nations with high income and developed economies, an upgrade that provided it with a global “stamp of approval” of its economic policies and progress.
As a result, the world’s major global benchmark index providers upgraded Israel from the status of an emerging market to that of a developed market, including in 2009 by FTSE, in 2010 by MSCI and later by S&P Dow Jones Indexes.
“While Israel’s graduation by the three primary global index providers was widely considered appropriate and well-justified, its impact on the local stock exchange was initially negative,” said Schoenfeld, the CEO of MV Index Solutions, by email.
“Israel went from being a medium-sized market within the Emerging Markets indexes to a tiny weight in global Developed Market indexes.”
The MSCI Israel Index was reclassified in 2010 from Emerging Markets to Developed Markets, and was included in the MSCI World Index, the organization’s primary developed market benchmark; the MSCI EAFE Index (Europe, Australasia, and the Far East); and the MSCI Europe and Middle East Index.
But the weight of Israel in the MSCI World Index dropped to 0.37% from the 3.2% weight it had in the MSCI Emerging Markets index.
“In the emerging market, we were a big fish in a small pond. We were considered a very strong country among the emerging markets,” said Offir Eyal, director of the international affairs and business development department at the Israel Securities Authority (ISA), the capital markets regulator. “But among the developed nations, our economy is relatively small.”
The upgrade triggered an abrupt outflow of foreign investment from the Israeli capital market of some $2.5 billion, Eyal said.
In addition, at the time of the reclassification, the Israel index was not included — and still isn’t — in any of the leading regional indices, such as MSCI Europe or MSCI Pacific Indexes. Instead MSCI created a new regional developed-market index, the MSCI Europe & Middle East index, which includes developed European markets and Israel.
This move “somewhat orphaned” Israel, said Schoenfeld. Indeed, since then, Israel has been the only equity market classified as “Middle East” in the MSCI World Index, and stands alone in the “Developed Middle East” category.
“The problem is that this new regional index didn’t catch the attention of investors,” said the ISA’s Eyal. “For an index to succeed there need to be financial products that use it; just to have an index is not enough. All of the impact comes from the money that tracks this index. But this new index did not catch on. It didn’t become a benchmark index, it didn’t become popular, and there are no assets tracking it.”
As a result, the ISA said in a presentation, global passive and active investors have effectively “limited exposure to Israeli companies traded worldwide.”
At the prodding of the ISA and the Tel Aviv Stock Exchange, MSCI in June 2012 initiated a survey of investors, similar to what it is doing now, in a bid to add the Israel Index to the MSCI Europe gauge.
The Israeli officials hoped at the time this would help boost trading volumes, which had fallen some 44% between May 2010 to end 2012, according to a Bank of Israel report published in March 2013. The country’s switch to developed market from emerging in 2010 was one of the factors contributing to a trading decline in Tel Aviv, the central bank said, as funds tracking the European Index didn’t have an incentive to switch.
Being added to the MSCI Europe index would lead to between $1 billion to $2 billion in added foreign capital to Israeli shares, Ester Levanon, then CEO of the Tel Aviv Stock Exchange, estimated at the time, according to a report in Bloomberg.
But at the conclusion of the investor poll, MSCI said in June 2013 that a strong majority of global investors didn’t see Israel as part of their European investment opportunity set.
The ISA and the Tel Aviv Stock Exchange have now again lobbied the MSCI to try once more, in a hope that this time, in February 2022, the answer from investors will be a “yes” for a reclassification.
“It is important for the Israel capital markets to have foreign investors,” said the ISA’s Eyal. It helps connect the market to the rest of the world, diversifies opinions, and makes the market less concentrated. And one of the most significant ways to introduce foreign investors to the market is via leading international indices, he said. “MSCI is the biggest maker of indices in the world,” he added.
“I think our case is good, there is justification” for a reclassification this time, Eyal said. Israel is in many respects “already part of Europe,” he added.
The nation is part of various international committees and forums, such as the International Monetary Fund’s Euro Area, the European Bank for Reconstruction and Development and The Federation of European Securities Exchanges (FESE).
Its economic indicators are also more aligned with European nations than those in the Middle East, Eyal said.
The nation’s economy grew 6.5 percent in 2021, according a Bank of Israel estimate, and its government debt to GDP ratio, at 71.7% as of December 2021, was higher than that of the Netherlands but below that of Germany, Finland, Belgium, or the UK, according to Bank of Israel and OECD data. Per capita GDP is $43,000, and the nation has an AA- credit rating at S&P. The shekel is one of the strongest currencies in the world; Israeli public companies can be dually listed on other exchanges such as the Nasdaq, the NYSE, and LSE, and are encouraged to publish corporate responsibility and ESG risk management reports.
“Geographically, Israel is where it is,” said ISA’s Eyal. “But economically, we think the market is similar to that of Europe. There are differences of course, but regarding its quality, strength, depth of the capital market, the variety — it is certainly relevant.
“We believe that given the great progress of the Israeli economy and capital markets, the solid Israeli currency, the strong tech sector, this time the reclassification greatly serves the interest of international investors. It will clearly improve the European index,” Eyal added.
Israel’s prospects for inclusion in the MSCI Europe Index this time around are “better for a variety of reasons, but still far from certain,” said Schoenfeld.
“Israel is a bigger and more significant market” than it was in 2012-13, he said, and its tech sector, when measured by Israeli companies listed both in Tel Aviv and abroad, would provide MSCI’s Europe Index “with substantial added tech exposure and overall diversification.”
The inclusion of Israel in MSCI Europe would benefit investors as it would give them greater exposure to Israel’s tech sector, Schoenfeld noted.
Active fund managers whose mandates are restricted to companies included in European benchmarks are often not allowed to invest in Israeli firms, or are highly restricted in their ability to invest beyond the benchmark, he explained. These would have “missed out on more than 40 Israel unicorns that went public on global markets, mostly on the TASE, NYSE and Nasdaq, in the past few years.”
These same investors could also miss out on some of the major Israeli private companies that will be, in future, holding an initial public offering of shares, as the nation is home to 8% of the world’s tech unicorns, and has more startups per capita than any other nation, Schoenfeld added. Unicorns are privately held tech firms valued at over $1 billion.
“In contrast to Israel, Europe has a relative dearth of large technology firms and technology startups. This reclassification will give investors in the European index greater access to the dynamic Israeli tech sector,” Schoenfeld said. “For example, the broad-based BlueStar Israel Global Index, which includes Israeli technology stocks listed worldwide, comprises approximately 40% technology stocks, in contrast to the MSCI Europe IMI Index, which only has 8% tech exposure.” The BlueStar Israel Global Index is one of the indexes of MV Index Solutions.
The MSCI Israel Index included 15 companies as of December 2021, with Nice Ltd, Bank Leumi Le-Israel Ltd, Check Point Software Technologies Ltd., Bank Hapoalim Ltd., Teva Pharmaceutical Industries Ltd. and Wix.com ranking in the top six places, with the heaviest weightings in the index. In 2021 the predominant sector in the MSCI Israel Index was information technology (IT), with a weight of 37.3%, followed by financials, with a 31.4% weight, according to MSCI.
If Israel were to join the MSCI Europe Index, it would likely have a weight of some 1%-1.5% in the index, said the ISA’s Eyal. All of the 15 companies in the MSCI Israel Index, which are incorporated in Israel but have shares traded on the TASE or on Wall Street, would be added to the main European index, while some 100 other Israeli companies may be added to more specific indices originated from MSCI Europe. There are dozens of these, he noted.
As part of the new consultation, launched in December 2021, MSCI asks investors how they view Israel’s regional classification in terms of index inclusion: Do they see Israel as part of the Middle East, European, Asian or other investment opportunity sets? It also asks investors how they, in general, consider regional classifications: Do they see them in terms of geographical proximity, shared macroeconomic characteristics, or in other terms? And it also asks if MSCI should change the index regional classification for the MSCI Israel Index.
In a note to investors published earlier this month, Barclays estimated that being part of MSCI Europe would boost trading volumes and inject money into Israeli stocks. “We estimate this move would boost trading volumes, bring close to $1 billion in passive investments and potentially generate a significant increase in active investments,” wrote Barclays analyst Tavy Rosner.
Not only that, said Schoenfeld. “If MSCI was to classify Israel within its Europe regional benchmarks, it would likely compel other major index providers, such as FTSE Russell and S&P Dow Jones, to similarly consider reclassifying Israel, potentially multiplying the above-mentioned benefits for Israel’s capital markets.”
A day to remember
Capital market veterans well remember May 26, 2010, when Israel moved to the developed markets index from the emerging markets index.
“You can’t forget that day,” said a player in the local capital market. There was “a crazy” NIS 16.4 billion (Hebrew) in turnover that day ($5.2 billion at current exchange rates), he said, mainly in the closing session of the stock exchange, which was about “10 times more than the daily average for that period.”
The closing time of trading was extended twice, from 4:30 p.m. to 5:30 p.m. and then to 6 p.m., to enable traders to handle the deluge of selling and buying orders from investors and fund managers: emerging market investors had to divest all of their holdings in the Israeli index as it moved to the developed market indexes, while developed market investors bought into the reclassified Israeli index. The net result yielded the aforementioned $2.5 billion outflow of funds.
“It was nuts,” said another trader, who in 2010 worked at Clal Finance Ltd., an Israeli financial services provider. “It was the busiest day I have ever had in my 20 years of being a trader. Imagine a room full of people that are running around with their hats on fire. Clients whom you hadn’t heard from in six months were calling you and giving you NIS 20 million in orders, to sell at any price. Phones were ringing off the hook.”
The market players now hope Israel gets added to MSCI Europe, but are cautious in their optimism.
The chances of being added to MSCI Europe are better today than in 2013, said the former Clal Finance trader, and such a move would bring “more investor eyes to this country.”
“We are culturally closer to Europe than to the Middle East,” the former Clal trader said. But the odds of a go-ahead from investors are “probably still very, very low.”
The analyst at the investment bank that said that while being added to MSCI Europe would be “hugely significant” for the local capital market, should it happen, “it is anything but a foregone conclusion and would be challenging.”
One reason for European fund managers opposing such a move is the fact that the Israeli trading week is from Sunday to Thursday as opposed to Monday to Friday for the majority of the world, he said.
“I am of the view that it is going to be challenging,” said the analyst. “People think in terms of what is easiest for me: Do I want to trade something that doesn’t trade on a Friday and trades on a Sunday? This is a big black mark. Am I going to have to work on a Sunday because I have stocks trading? No, I don’t want to. Or, am I going to be looking at another currency which is a non-European currency? No. It adds complications to my portfolio and how I build my portfolio.”
Perhaps the lobbying of the ISA and TASE with global investors will pay off, the analyst said. “But it will mean a big change for the clients and the way they are doing things. For them, it means another country they need to cover and get familiar with. It is not a country in mainland Europe, it is a country where they would need to get on a plane for four or five hours, which doesn’t speak a European language, where they have different holidays and are not off for Christmas. These are all technical things, but I am guessing it matters for people. Then there are all the geopolitical complexities that surround Israel.”
“I am not saying it can’t happen,” the analyst said. “It can happen, and if it does happen it will be hugely significant. I just think that it would not be a surprise if it does not.”
The ISA’s Eyal also admits there is a chance that MSCI clients will once again say no, as they did in 2013. If that happens, he said, then the ISA will continue with its efforts to expose foreign investors to local companies and their stocks.
“We will continue to do all of the intensive work we do on many fronts to increase the advantages of the Israeli capital markets and to open it to the world,” he said.
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