Israel Gets an Upgrade, and Investors Depart

A move by MSCI, the creator of stock market indexes, to reclassify Israel as a developed market rather than an emerging one has led some big investors to abandon the country. Harvard University and mutual fund companies T. Rowe Price (TROW) and Eaton Vance sold a combined $210 million in Israeli stocks from their emerging-markets investments last quarter, according to Bloomberg estimates.

Many money managers use indexes as the basis for allocating investments. Funds focusing on mature economies have been slow to buy Israel shares because the country accounts for just 0.4 percent of MSCI's (MXB) developed-markets index, compared with about 3 percent of its emerging-markets measure. "Israeli stocks might be in no-man's-land for a while," says John Derrick, director of research at U.S. Global Investors (GROW) in San Antonio. "It's small enough in the developed market index to avoid altogether." U.S. Global's Global Emerging Markets Fund (GEMFX) sold 9,346 shares of Israel Chemicals (ICL) during the second quarter, according to data compiled by Bloomberg.

The shift has hurt Israeli stocks. The Tel Aviv 25 Index climbed 2.8 percent from May 27, when Israel was added to the developed market measure, through Aug. 31, trailing the 7.3 percent increase in the MSCI Emerging Markets Index and the 4.9 percent advance of the MSCI EAFE Index, which Israel joined.

Derrick says the country may attract new funds after a transition period because it has stronger economic growth than other developed markets. Citigroup (C) estimated in March that $2.8 billion from index tracking funds would pull out when Israel was reclassified, and $3.6 billion would eventually enter. Teva Pharmaceuticals (TEVA), with a market value of $48 billion, and Israel Chemicals, at $16.5 billion, are the two biggest stocks in the Tel Aviv 25 Index.

In 2002, professors and students from Harvard and the neighboring Massachusetts Institute of Technology called on the universities to divest from Israel and from U.S. companies that sell arms to the country, to protest Israel's occupation of Palestinian territory. Harvard's sales in the second quarter reflect the change to the MSCI emerging markets index and don't represent a divestment from Israel, according to John Longbrake, a Harvard spokesman. Harvard is continuing to invest in Israel through the outside managers who handle most of the endowment, Longbrake said.

The MSCI upgrade reflects diminished concern by investors over geopolitical risks when buying Israeli stocks, according to Frank Nielsen, an executive director at the New York-based firm. Israel had already satisfied developed market criteria related to economic sustainability, market size and liquidity, and market accessibility. Israel was MSCI's first upgrade since Greece was moved up in 2001. The Athens Stock Exchange General Index lagged behind the Stoxx Europe 600 Index by 8 percentage points in the 12 months following the promotion on May 31 of that year.

The bottom line: Being upgraded to a developed market has made Israel a little fish in a bigger pond. Rapid growth may lure investors back.

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