Stocks in South Korea, Taiwan and India could bear the brunt of MSCI's decision to add 14 U.S.-listed Chinese companies to its Emerging Markets index.
The mainland currently holds a 23.9 percent share in the $3.5 trillion market-cap global benchmark, and that's set to widen to 26.2 percent by next year, following the addition of heavyweight tech names including Alibaba, Baidu and Qihoo 360 Technology.
MSCI will add the companies at half their December 1 free float-adjusted market capitalization—i.e. the value of the shares held by the public—and then include the remainder at its May 2016 semiannual index review.
Once the changes are fully implemented next year, around $7 billion could move into these American Depository Receipts (ADRs) as passive funds that track the MSCI index snap up the assets, according to widespread estimates.
Because these funds mimic the MSCI index, investors are likely to rebalance their portfolios to match the new weightings, which could result in the "crowding out" of other markets, strategists say.
South Korea, Taiwan and India hold the highest individual MSCI EM index weightings after China at 16.1 percent, 12.3 percent and 8.4 percent respectively, so they are the most likely to see their weightings reduced in order to make space for the incoming Chinese ADRs.
MSCI has yet to release the new ratios of its country allocations, but the three Asian economies could see an estimated decrease in weight of about 55, 45 and 30 basis points respectively by May 2016, said Tobias Bland, chief executive of Enhanced Investment Products.
"Markets in Korea, Taiwan and India may see a knee jerk reaction at first but we'll have to wait until passive funds actually add ADRS to their portfolio to assess the real impact," said Bernard Aw, IG's market strategist.
But that adjustment process could take at least anywhere from three to six months as foreign fund managers adopt a cautious approach to Chinese stocks amid a slowing domestic economy, Aw added.
Hong Kong stocks on the MSCI EM index, however, could get a long-term boost despite an initial minor cut in weighting since many are directly linked to China, Aw noted. Thus, if investors reallocate portfolio space to Chinese ADRs, they may include more Hong Kong companies as well.
Ultimately, how long the "crowding out" effect lasts depends on how seriously Beijing takes its financial and markets reform agenda, warned Alicia Garcia Herrero, chief economist at Natixis.
"This is a great opportunity for China to show off its reform efforts. These ADRs may be listed in the U.S. but they are still reflective of the mainland. If investors are unconvinced by Chinese reforms, the 'crowding out' effect could reverse and see other emerging markets benefit."
Market participants have long awaited progress on capital account liberalization and full renminbi convertibility for concrete signs Beijing is serious about transiting into a more market-oriented system.
The same logic applies to the renminbi's entry into the International Monetary Fund's basket of reserve currencies on Monday, While the news did bolster optimism regarding Beijing's commitment to reforms, it remains to be seen whether the mainland is willing to sacrifice market stability to gain international credibility, according to Herrero.