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Geography Is Not Destiny

Israel and Financial Securities Indexes
by glenn yago

glenn yago is senior director at the Jerusalem Institute’s Milken Innovation Center and senior fellow/founder of the Milken Institute’s Financial Innovations Lab. He teaches finance at the Hebrew University of Jerusalem School of Business and the University of California (Berkeley).

Published March 30, 2022


Is Israel part of the Middle East? It certainly lives in the neighborhood, surrounded by Syria, Saudi Arabia, Lebanon, Jordan and Egypt. And, in any event, who cares whether Israel is labeled as such?

There is, in fact, one odd — but not unimportant — way in which the label does matter. Much to the dismay of the Israeli finance sector, MSCI, the American company that maintains securities indexes of all sorts for the convenience of global investors, has just reiterated its position that Israel is part of the Middle East for securities indexing purposes.

Israel retains the distinction of being the only developed country segregated from a major geographical index in Europe or Asia. And if the past is indicative, that decision will cost Israel billions of dollars in investment inflows annually. But before I explain, indulge the nerd in me for a few paragraphs of history.

What’s in a Name?

The term “Middle East” was popularized in Britain in 1902 by an American admiral, Alfred Thayer Mayan, to describe the region of competing imperial interests surrounding the Persian Gulf and the Arabian Sea. Despite this original definition, Israel’s geographic proximity has always leaned westward toward the closer European and North African Mediterranean prior to the 20th century.

By then, the British, in particular, were wary of Russian ambitions, and mindful of the need to protect sea channels and trade flows to and from India and other British-controlled lands. Not too many years later, another American, Woodrow Wilson’s advisor Col. Edward House, predicted that this Middle East, soon to be carved up into post-Ottoman spheres of influence, would become “a breeding place for future war.”

So, what’s in the name these days? Without the historical association to ill-fated geopolitics, not much beyond geographic proximity. Today’s Middle East offers no shorthand for describing common resource endowments, capital stocks and flows, economic culture or political institutions that would make the countries similar in terms of investment prospects. Put simply, the economic prospects of Saudi Arabia, Jordan, Egypt and Israel are hardly on parallel tracks. Economic regions are now self-organizing in a “geography of connectivity” that will not be held hostage to a legacy whose political baggage grows ever heavier with time.

A Liability of Labeling

For the present, however, some of these self-organizing economic regions are struggling against the misperceptions of labels that exact real costs in terms of their ability to attract financial capital and to link their prospects in the minds of investors to larger, more familiar markets.

Israel, which joined the OECD in 2010, is a prime example. At the time of Israel’s graduation to high-income developed country status, the major global stock indexes, including those created and managed by MSCI, upgraded the country. MSCI created an index specifically to reflect that reclassification — its Europe and Middle East Index.

The nominal goal (for the Israeli finance industry, anyway) was to open Israeli markets to a large pool of global investors — in particular, those who wished to invest passively through index funds covering developed economies. But a funny thing happened on the way to the forum. Investors ignored the new index, which was viewed as merely a revamp of the European Index with a Middle East sidebar.

Israeli markets were effectively excluded from material research and investment coverage, isolated with no relevance to meaningful peer benchmarks that serve as standards of financial performance. And the financial sector took a massive hit. Foreign portfolio investment fell and local portfolio outflows rose. From 2010 to 2019, the average daily trading volume on the Tel Aviv Stock Exchange (Israel’s only public stock exchange) dropped by 37 percent to $365 million. The IPO market ground to a near halt, and de-listings rose.

The unanticipated grim experience ensuing from Israel’s index “graduation” back in 2010 reinforces the argument that global investors should evaluate markets that group by similarly structured economies, as opposed to physical geography.
Who Will Tell the Investors?

Yet despite those dramatic declines in liquidity, Israeli technology and growth companies have prospered over the past decade — not for nothing has Israel earned the title “Startup Nation.” But many of these firms just can’t afford to stay in Israel because they lack access to the capitalization and investors needed to scale. The limited index classification means that many local firms can capture only a small portion of the global technology value chain (with funding often limited to high-end R&D) prior to being acquired through premature exits. Nor can they attract higher valuations to build runways to expansion.

By 2021, however, the Tel Aviv Stock Exchange (TASE) was leaning into recovery mode, and pressure was building to change Israel’s index classification. There has been a flurry of recent IPOs, thanks in part to some exchange-driven initiatives to expand liquidity. These include greater reporting transparency and new securities designs, as well as new attention to creditor and minority shareholder rights.

The IPOs and other TASE listings provide access to a trove of companies that specialize in cleantech, fintech, food technology, cybersecurity, and medical devices scaling up in the Israeli market. These kinds of firms accounted for some 65 percent of new issuances for 2021. Today, the country’s robust technology ecosystem ranks No. 1 and 2 globally for per capita startups and per capita expenditure in R&D, respectively.

The recent opening of Gulf state markets to Israel is also encouraging. But the hard truth is that classifying Israeli markets as Middle Eastern doesn’t capture — in fact, it distorts — the realities of Israel’s global and inter-regional trade.

In fact, the unanticipated grim experience ensuing from Israel’s index “graduation” back in 2010 reinforces the argument that global investors should evaluate markets that group by similarly structured economies, as opposed to physical geography. As such, Israel’s trade and investment markets have much more in common with European and global markets as a whole, than with the oil-dominated markets of its regional neighbors. Including Israel in MSCI’s Europe Index would give passive and active global investors greater exposure to Israel, its role as a global nexus of successful and expanding tech hubs, and its stable currency.


So why did MSCI reject pleas to move Israel from the hodge-podge of the Europe and Middle East Index to the straight European Index? Perhaps, in part, concern that the reassignment would be confusing to investors — Israel, after all, is not part of geographically defined Europe. And perhaps MSCI was concerned that departure from geographic assignment for Israel would open the door to pressure from other countries that believe MSCI-based index funds would find them more attractive in some other category.

But the reason cited by MSCI after consulting with the funds that are its primary clients is the difficulty of coordinating trading between TASE, which operates Sunday through Thursday, and the European exchanges that follow the Monday through Friday convention. This, in spite of the fact that the Israel Securities Authority had stipulated from the beginning of MSCI’s review that it would change its trading schedule if that proved to be the main barrier to inclusion.

All this is understandable, but, in my view, bad news for both Israel, which is losing capital flows, and retail investors who must turn elsewhere to diversify into Israel’s tech miracle. One can only hope that the ongoing awkward fit will convince MSCI to reconsider in the near future.