There is a rabbinic saying that “it is better to be the tail of a pride of lions than the head of a leash of foxes.” But, like all general rules, this one has exceptions – and stock markets may be one of them. If the experience of the Tel Aviv Stock Exchange (TASE) is anything to go by, it may be better to be in the supposedly minor league of securities markets classified as emerging than be upgraded to play in the major league of developed markets.

That, at least, is how some analysts are explaining the slump in trading volume on the Israeli stock market over the last year or so. But there are other possible explanations for what or who is responsible for the mysterious shriveling of turnover in Tel Aviv. Michael Klahr, Citibank’s director of Israeli equity research, believes that “a bit of everything” has contributed to the malaise in Tel Aviv.

At least the key facts in this mystery are undisputed, the central one being that in 2012, trading volume in equities on the TASE has slumped. According to data collated by the World Federation of Exchanges, equity trading on the TASE in January-September 2012 amounted to $35.5 billion, a massive 47% fall from the same period in 2011. For the whole of 2011, TASE equity volume was $81.8 billion, itself down over 20% from the 2010 total. An immediate response to this might well be to ask: “What’s the big mystery in that? Trading volumes have fallen all over the world. If Tel Aviv’s volume had not fallen, that would be surprising, and you would need an explanation.”  But when the Tel Aviv data are looked at in a wider context, the extent of the problem becomes clear.

Granted, equity trading volumes are down everywhere. According to Joseph Wolf, head of equity research at Barclays Capital’s Israel office, this reflects “a loss of appetite on the part of big investors.” However, WFE data for all global bourses and for those in specific regions shows that in January-September 2012, trading volume globally was 25% lower than in the parallel period of 2011, with only minor differences between the main regions. But Tel Aviv, as noted above, posted a decline of almost double that rate, at nearly 47%.

Moreover, the rapid fall in trading volume in Tel Aviv began in late 2011. Before that, in the post-crash years of 2009 and 2010, volume in Tel Aviv had either fallen less than the global average (as in 2009) or risen faster (as in 2010). In other words, Tel Aviv had formerly been a global outperformer in terms of trading volume, but over the past year it has become a massive underperformer. Looking further into the past, during  the boom years preceding the crash, the expansion of trading volume in Tel Aviv was either much faster than that of the global total (as in 2003-2005) or similar to it (in 2006-2007). In other words, after a decade in the front rank of activity growth, last year TASE suddenly became a global laggard.

There is also a domestic context to this trend. Unlike most bourses, the TASE encompasses regulated markets in equities, bonds (government and corporate) and derivatives, with data for trading in all these types of securities readily available. In contrast, in many countries, part or all of the bond market activity is conducted over-the-counter and hence is less easily measurable. The Israeli data show a sharp dichotomy: While equity volumes have been shriveling, bond volumes have been soaring. They have hit new all-time records this year as investors, and especially institutions, have sought relative safety.

The mystery in Tel Aviv is that the situation is more complex than it might appear at first sight. At least two questions need to be answered. First, why is equity volume shrinking on the TASE much more than elsewhere? Second, why has this happened over the past year, though previously Tel Aviv had been in better shape than most other markets?

An Upgrade Backfires

Some people in Israel, including the senior management of TASE, believe that it is MSCI – formerly Morgan Stanley Capital International — which is responsible for the decline in equity trading volumes, although the outcome was an unplanned result of what was supposed to be a positive development. To understand what happened requires a detour into the arcane world of stock indices and their impact.

MSCI is among the most important companies engaged in creating and managing stock market indices. Among these indices are some that cover the entire world, others related to regions and still others based on industries and sectors or investing styles. But in all of these, MSCI, like almost everyone else in the investment business, makes a distinction between developed markets and developing ones.

Yet no clearly-defined or commonly-agreed criteria exist for defining the terms “developed” and “developing.” Everyone is free to create their own guidelines, at least in theory. But in the real world, MSCI’s definitions and classification of each market carry enormous weight. That’s because most fund managers measure their performance, and/or are measured by others, in relationship to a “benchmark” which, in many cases, is based on an MSCI index.

The indices are dynamic in the sense that the weighting of specific markets within them changes over time. Even more importantly, though, markets can move from one index to another in line with changes in their degree of development. At some point, a market becomes so mature and sophisticated that it meets the criteria of being called a developed market and is reclassified accordingly. The move from being a developing market to a developed one is generally regarded as a compliment to the market in question and hence is termed an upgrade. A move in the opposite direction is considered a shameful downgrade, to be avoided at all costs.

In Tel Aviv’s case, there had long been some dissonance between the degree of development of the Israeli economy, which met virtually all developed economy standards, and that of the nation’s securities market, the TASE, which was categorized as emerging. Furthermore, for most investment houses, brokers and other players on the TASE, this state of affairs was considered desirable. They viewed the Tel Aviv market as what Joseph Wolf terms “passive aggressive” — meaning that, relative to most emerging markets, it was more stable and therefore served as an anchor in an emerging market portfolio.

However, in 2008 MSCI told the TASE managers that their market was ripe for upgrading to developed market status, subject to its meeting certain technical criteria. The TASE rose to the challenge and, in little more than a year, had met all the MSCI requirements – “much to their surprise, because these things usually take much longer,” in the words of a senior TASE executive. In September 2009, therefore, MSCI announced that, starting in May 2010, TASE would be upgraded.

Satisfying as this was, the upgrade created a problem. As an emerging market, Tel Aviv had many peers in the relevant regional index for EMEA (Europe, Middle East and Africa). But there were no developed markets from this region for Tel Aviv to join. There was, of course, a European-region developed market index, but MSCI was reluctant to include Israel in Europe since, on a geographical basis, it is in the Middle East or West Asia. The somewhat contrived solution was to create a new region, called “Europe and Middle East,” which encompassed all the existing European developed markets as well as Israel. But the many funds that used the MSCI Europe developed markets index as their benchmark had no incentive to switch to the new index and preferred to stick with the old and familiar one.

This resulted in “Tel Aviv falling between the cracks as far as passive fund managers were concerned,” notes Citibank’s Klahr. Passive funds invest in each country in line with its weight in an index so that, while passive emerging market funds had previously been investors in Tel Aviv, they were obliged to sell out in May 2010 because the upgrade meant that Tel Aviv no longer met their emerging market mandate. The assumption that they would be replaced by their developed market peers proved mistaken, because Israel was not in a recognized and widely-used developed market index.

As for the active fund managers – those who make conscious decisions as to how much to invest in each country within their investment universe,  rather than follow rigid formulae set by index composition – they also had little incentive to invest in post-upgrade Tel Aviv. The weighting the Israeli market carried in the Europe and Middle East developed market index was negligible – less than half of 1% – and fund managers were not prepared to devote scarce research resources to analyzing such a marginal market and the companies traded on it.

What Could Be Done?

D-day for the upgrade was May 26, 2010, when trading volume on the TASE broke all records as the foreign funds shifted out or in, depending on whether they were oriented toward emerging or developed markets. For the reasons noted above, the net foreign involvement in Tel Aviv dropped at first, but gradually recovered later – and overall trading volume was strong in 2010 and for most of 2011. Only later that year and in 2012 did it fall sharply. So how can the MSCI move implemented in May 2010 be responsible for the fact that volume began declining 18 months later?

Joseph Wolf of Barclays Capital believes that the upgrade had an impact, and that the effect was indeed delayed – but that it is at most a minor factor. In his opinion, the cause of the volume slump should be sought at home, not overseas. “A major issue is the fact that 50% of the new money invested in equities by institutions such as pension funds is going overseas.” Wolf does not necessarily blame the domestic institutions for turning their backs on their home market: “Key sectors of the Israeli market, such as telecoms, banks and oil companies, have all been made much less attractive to foreigners and domestic investors because of regulatory or legislative intervention over the last two years.”

Citibank’s Klahr offers a different take on the situation. He views the period of rapid and sustained growth in trading volumes, from 2003 until last year, as akin to the biblical “seven good years” to which a reaction — or “correction” in traders’ jargon — is almost inevitable. Klahr recalls that in the harsh market environment of 2000-2002, most of the foreign banks closed their Israeli capital market operations. “By 2002, only UBS had survived. Since then, many more have opened up and expanded their Israeli offices, including Citibank, Barclays, Deutsche and others. Now there is something of a shake-out – but this is a cyclical business,” he notes.

Implicit in this approach is that there isn’t much to be done beyond sweating out the market cycle. But most people are not prepared to be so long-suffering and prefer a more activist response. The TASE management believes that MSCI could help matters simply by moving the Tel Aviv market to the European developed market region and its index, thereby opening the way –- indeed, virtually ensuring –- that passive investment funds would include Tel Aviv in their portfolios. That extra liquidity could spark a virtuous circle which would see foreign active managers become more involved in Tel Aviv and persuade domestic institutions to channel more of their investment shekels to the local market, instead of sending them to supposedly greener pastures abroad.

Wolf from Barclay’s Capital agrees it is a good idea for the TASE to lobby MSCI, “but it needs to be done carefully.” In any event, even a successful outcome in this regard “would be good, but not crucial.” He believes the TASE could do much to help itself in its own backyard. “The main stock index on the Tel Aviv market is the TA-25,” Wolf explains. This contains many holding companies that are of little interest to investors looking for specific companies with outstanding prospects rather than conglomerates. This is especially the case for foreign investors. The primary attraction of Israel to foreigners is its high-tech companies, but very few of these are included in the TA-25.

“The TASE should aim to get more high-tech companies onto the index, for instance by making the size of a company’s free float [shares not closely held by insiders] and the quality of its corporate governance the key criteria for inclusion,” Wolf notes. “That would not only boost investor confidence in the stock exchange and its companies, but it would also spur foreign interest and have a positive impact in both the short and long term.”