How Foreign Ownership Rules Impact Passive Funds

When investing in emerging markets investors must accept an increased investment risk of government intervention - such as changes to foreign equity ownership rules

Kenneth Lamont 21 August, 2015 | 9:18
Facebook Twitter LinkedIn

In June this year, the Prime Minister of Vietnam announced that foreign investors would no longer face restrictions when buying shares in many Vietnamese companies.

The changes due to come into force in Vietnam in September will scrap the 49% cap on consumer goods and industrials companies, among others, allowing foreign investors to purchase up to 100% of available shares in a company.

Certain caps, such as those on financial stocks will remain in place.

The proportion of a listed company that is owned by investors outside of where the company is listed is called foreign equity ownership.

Benchmarks tracking equity markets subject to restrictions on foreign ownership, such as the FTSE Vietnam, typically employ a free-floating market capitalisation methodology. This means that individual stock and wider sector weightings are calculated on the basis of their theoretical availability to international investors. In practise, the ‘foreign room’, or quantity of shares actually available to buy is much smaller due to existing foreign holdings, and in many cases reaches zero.

In the case of the FTSE Vietnam, as the caps are lifted for some sectors, their amount of free-float will increase dramatically, while remaining restricted for others. This is expected to result in a significant re-allocation of sector weightings within the index. 

For instance, the increase in free-float in a sector like consumer goods is likely to see it grow as a percentage of the index at the expense of financials, which currently represent 62% of the benchmark and will continue to be restricted by ownership caps. This is bound to change the nature of the index’s underlying exposure and thus its future performance.

This has potential implications for ETFs currently tracking the Vietnamese market. This is because, unlike within an active fund, which can exercise discretion when building a portfolio, a passive fund is obliged to reflect the performance of the underlying benchmark.

Investors may be unnerved by a shift in fund exposure from one day to the next. However, changes like these should be viewed within a wider context. Reductions in capital controls are widely considered a positive step towards more open and efficient markets.

In the particular case of Vietnam, the move may also precipitate an upgrade to emerging market from its current frontier market status. This in turn could be expected to see the country attract additional foreign capital; something that would be duly reflected by ETFs tracking it.

Indeed this was the case for Qatar, which in the wake of raising foreign ownership caps from 25% to 49% in August 2014 was upgraded to emerging market status by MSCI and experienced a surge in inflows of international capital.

Vietnam Not the Only Country Impose Restrictions
Emerging markets such as Qatar, India and China do still maintain foreign ownership limits on equity as a protectionist measure to shield fledgling industries from the rigours of international competition and the potentially damaging surges of capital. In fact, albeit less frequently, restrictions on ownership also exist in developed markets. For example, in the USA, there are currently foreign ownership restrictions on equities in the airline industry. However, these measures are usually enforced for political rather than economic reasons. Generally speaking, when investing in emerging, and to a greater extent frontier markets like Vietnam, investors must accept an increased investment risk of government intervention. In addition, investors favouring passive funds should monitor developments to anticipate the possibility of substantial changes to the underlying indices. 

Facebook Twitter LinkedIn

About Author

Kenneth Lamont  Kenneth Lamont is a Passive Funds Research Analyst for Morningstar Europe.

© Copyright 2022 Morningstar Asia Ltd. All rights reserved.

Terms of Use        Privacy Policy