are South Korea and Taiwan emerging markets?: implications for index mutual funds/ETFs

Korea and Taiwan aren’t emerging economies…

Korea has been a member of the Organization for Economic Co-operation and Development, the association of developed nations, since 1996.  Taiwan would presumably be a member, too, if it were not for China’s insistence that Taiwan is not a separate country, but a prodigal province of the mainland.

On a GDP per capita basis, Korea and Taiwan rank #33 and #37 in the world, respectively, just above the Czech Republic, which is also an OECD member.  On a Purchasing Power Parity basis, the two rank #25 and #20 by their per capita GDP–around the same level as the UK, France and Japan.

Looking at their place in world trade, neither is an exporter of raw materials or agricultural products in the way Australia or New Zealand (both classified by index compiler MSCI as developed countries) are.  Instead, both sell advanced technology and machinery products, like computers and smartphones.

…but their stock markets aren’t well-developed.

My experience is that company financial statements aren’t reliable in either country.  Neither governments nor company managements in either country care to have foreigners as shareholders, and treat them poorly.  There’s also a significant amount of intrusion into market workings by politically powerful entities in both.  The fact of this interference isn’t the issue; that happens everywhere.  It’s the extent–and maybe my lack of familiarity with the local rules–that bothers me.  In this regard, both Taiwan and Korea seem to me like Japan, only on steroids.

Every one of these factors is characteristic of emerging markets, not developed ones.

is MSCI about to reclassify both stock markets as developed?

There’s nothing new about what I’ve written above.  It’s been the situation for at least a decade (in stock market terms, it was worse before).

What is new, however, is that both the Wall Street Journal and the Financial Times have published recent feature articles suggesting that the MSCI will reclassify both Korea and Taiwan as developed markets later this month.

that might be an issue for holders of emerging markets index funds/ETFs

I’m most familiar with these entities in the US, but I think what I’m saying holds true for EU funds/ETFs as well:

Mutual funds/ETFs are both instances of a special type of corporation that is exempt from corporate tax.  It gains this exemption by, among other things, distributing all income (net of expenses) and realized capital gains to shareholders–who must pay tax on them.  Typically, distributions are made once annually, shortly after the tax year for the fund/ETF ends.

Together, Taiwan and Korea make up about a quarter of the MSCI Emerging Markets stock index (the largest other index constituents are China and Brazil).  If both countries are reclassified, index funds/ETFs will be required by their charters to sell all their Taiwanese and Korean holdings and reinvest the proceeds back into the revised Emerging Markets index.  That will presumably generate a large capital gain to be distributed to shareholders.

four quirks about a possible distribution

1.  It’s a fact of life about funds/ETFs that the holder who pays tax on a fund’s capital gain is the person who receives the distribution–not necessarily the person who enjoyed the rise in price of the stock that’s been sold.  If you buy a fund/ETF share today and receive a massive capital gains distribution tomorrow, you’re on the hook for any tax due, not the holder of the share while the capital gain was being amassed.

2.  Any distributions are net of any accumulated realized losses.  In the case of the Vanguard emerging markets index fund, which I hold, it had unrealized gains of $7.5 billion on April 30, 2011, the date of the most recent semi-annual report, but accumulated losses of $2.4 billion.

3.  Distributions are usually made at the same time every year.  For US funds, which typically have an October tax year, distributions come most often in late November or early December.  But a distribution can be made earlier–and often is, if the fund manager fears shareholders intend to sell their holdings to avoid receiving a large taxable distribution.  In other words, a Taiwan/Korea-related distribution could come as early as in July.

4.  Virtually everyone who buys a fund/ETF signs up for automatic reinvestment of distributions, so that the distribution itself results in almost no outflows. Only anticipatory sales, made to avoid a distribution, do that.

fund groups aren’t talking

I called up Vanguard the other day to ask about this issue.  My own back-of-the-envelope reckoning is that a distribution from the Vanguard emerging markets fund, if any, will be small (25% of the accumulated unrealized gains of $7.5 billion would be $1.9 billion, less than the $2.4 billion in accumulated losses).  And I own my fund shares in an IRA, so a distribution doesn’t affect me, in any event.  But I was curious.

My Vanguard representative was aware of the issue, but said everything depended on what MSCI does later this month.  I asked for the April 30th tax situation for the fund, but she wasn’t able to find it.  I looked it up online after I hung up.

relevant tax data are easy to find

Look for the latest annual/semiannual/quarterly report for your fund/ETF.   It will have a list of holdings and their market value (but not their individual cost basis).  At the end of the list, there’ll be aggregate cost and market value data.  In a section following right after that, the fund will show its accumulated realized losses.

2008 is a key year

The emerging markets index lost over half its value that year.  Although there’s no way of being certain with any individual fund, twenty some years of managing this type of money tell me that all the redemptions that created Vanguard’s accumulated losses came at the bottom or shortly after–probably in large part from people who bought shares in 2007.

Any fund/ETF that’s large now but was just getting started in 2008 probably has little in the way of accumulated losses to offset realized capital gains.  Entities like this are where the risk of a large taxable distribution are highest, in my opinion.  We’ll know more on June 21st, when MSCI does its next revision of the index.


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