FTSE Rebalancing Related Outflow: Opportunity or Threat

Staff Report:
FTSE Russell announced the reclassification of Pakistan from Secondary Emerging to Frontier Market status, effective Sep 23, 2024. This was an anticipated move as Pakistan’s market was placed on the watch list for possible reclassification on Sep 28, 2023.

The minimum criteria for Secondary Emerging status required a stock count of more than 2 in its standard index, an overall weight of over 5 basis points in the FTSE Emerging All Cap Index, and an investable market cap of more than US$4.07 billion.Pakistan Notifies Rules to Combat Cyber Threats

Pakistan failed to meet the criteria for stock count, as only one stock was able to meet the stock-specific requirement. The cumulative weight of Pakistan in the FTSE Emerging All Cap Index, based on our calculation, is 0.0509%, meeting the requirement, and the investable market cap is US$4.144 billion, also meeting the requirement.

Vanguard Group predominantly follows FTSE as its benchmark, and the total holding of Vanguard in Pakistan shares amounts to US$150-160 million as per our estimates, with the largest holdings in value terms being HUBC (US$23 million) and FFC (US$15 million). The top 3 ETFs/funds of Vanguard hold shares worth over US$120 million, or 78% of the total Pakistan holding as of May 31, 2024, we estimate. These Vanguard Funds largely adopt an index replication or index sampling approach with the objective to either track or closely track the performance of their benchmark indexes. This suggests Vanguard is likely to divest its holdings in Pakistan.

Based on the Bloomberg data and our shareholding analysis, Vanguard Group has already sold around 3.5-4.0 million shares of LUCK between Jan 2024 to May 2024, amounting to US$11-13 million.

We have conducted a fund-wise analysis for the top 3 funds that hold over 78% of the shares of Vanguard to understand whether the fund will sell all or part of its holdings in Pakistan equities”Topline said.

Vanguard Emerging Markets Index ETF/Fund:

Based on the Vanguard website, this is available both in mutual fund and ETF form. The total net assets of the fund under this category are US$105.8 billion. The value of Pakistan equities under this fund is close to US$55 million. Stock-wise positions are available on the next slide.

Benchmark Index: This fund and ETF are benchmarked to FTSE Emerging Markets All Cap China A Inclusion. Fund Objective: The primary goal of the fund is to closely track the return of the FTSE Emerging Markets All Cap China A Inclusion Index.

Our view: Since the benchmark of the ETF is FTSE Emerging Markets and the objective of the fund is to track the return of emerging markets, we believe Vanguard may divest its holdings under this fund.

Vanguard Total International Stock Index ETF/Fund:

Based on the Vanguard website, this is also available both in mutual fund and ETF form. The total net assets of the fund under this category are US$432 billion. The value of Pakistan equities under this fund is close to US$55 million. Stock-wise positions are available on the next slide.

Benchmark Index: This fund and ETF are benchmarked to FTSE Global All Cap ex US Index, which measures equity market performance in developed and emerging markets, excluding the United States.

Objective of fund: The primary goal of the fund is to closely track the return performance of the FTSE Global All Cap ex US Index, and the fund follows a passively managed, index replication approach.

Our view: Since the fund is managed passively with an index replication approach, we believe Vanguard may divest its stake in Pakistan.

FTSE All-World ex-US Small-Cap ETF/Fund:

Based on the Vanguard website, this is also available both in mutual fund and ETF form. The total net assets of the fund under this category are US$10.4 billion. The value of Pakistan equities under this fund is close to US$14 million. Stock-wise positions are available on the next slide.

Benchmark Index: This fund and ETF are benchmarked to FTSE Global Small Cap ex US Index, which includes stocks of companies located in more than 46 countries, including both developed and emerging markets.

Objective of fund: The primary goal of the fund is to track the performance of the FTSE Global Small Cap ex US Index, and the fund follows a passively managed, index sampling approach.

Our view: Since the fund is composed of equities from emerging and developed countries and is managed passively with an index sampling approach, we believe Vanguard may divest its stake in Pakistan.

Though the fund is expected to sell its holdings to the extent of up to US$150-160 million by the effective date of Sep 23, 2024, we believe the market has enough liquidity to absorb this selling pressure. However, we may see volatility and high volumes in certain stocks at the time of the selling in the market.

Amongst local investors, since 2024 to date, only insurance companies have remained net buyers to the extent of US$66 million, while all other local investor categories (i.e. Individuals, Mutual funds, Banks/DFIs, and corporates) have sold shares worth US$120 million since 2024 to date. We believe this Vanguard selling will be a good opportunity for local institutional investors and high net worth individuals to take sizable positions in these value-driven companies.

Foreign Investors Buying Momentum to Continue:

Foreign corporates have bought (net) shares worth over US$150 million in FY24 after witnessing selling of over US$2 billion in the last 8 consecutive years. We believe this momentum will continue as investor confidence is restoring due to improving economic indicators of Pakistan.

Increasing Size of Pakistan in MSCI Frontier Market:

We estimate the current size of Pakistan in the MSCI FM index at 4.6%, compared to less than 2% when it was added to the frontier index in 2021. This increase in weight is attributed to a whopping return of 94% in US$ terms in FY24, which almost doubled the market cap of companies. This increase in size will trigger more frontier funds to return to Pakistan, which currently are either underweight or have no exposure to Pakistan.

Pakistan Has Already Absorbed Selling of US$50-60 million of Two Funds:

Pakistan has already absorbed selling of US$23 million from iShares Frontier and Select EM ETF fund and US$33 million selling from Global X ETF since Jan 2024. The stocks in the portfolio of iShares were LUCK, HUBC, MTL, OGDC, ENGRO, SYS, PPL, POL, MARI, FFC, EFERT, MCB, HBL, and UBL. The top 10 holdings of Global X were HUBC, ENGRO, LUCK, EFERT, HBL, PPL, OGDC, MCB, MTL, and FFC.

Pakistan Market Trading at Forward Multiple of 4x:

Despite a 94% US$ return in FY24, the market is still trading at a 43% discount to its historic forward PE of 6.93x. The Pakistan market PE is trading at a 62% discount to its frontier market peers (historical discount 40%), which we believe will attract more frontier funds and local investors who are sitting on fixed income returns. We believe a shift of liquidity from fixed income to equities cannot be ruled out as interest rates are expected to come down by a further 400-500 basis points by Jun 2025. Our Index target for Jun 2025 is 106,000, which provides a return of 32%.