By Sree Bhaktavatsalam, Christopher Condon and Gillian Wee – Sep 2, 2010 7:00 AM

MSCI Inc. may have been more instrumental in changing investor behavior toward Israel than an eight-year-old divestment campaign by some Harvard and MIT academics.

The index provider”s decision to move the country to a developed nations index prompted Harvard University, T. Rowe Price Group Inc. and Eaton Vance Corp. to sell a combined $210 million in Israeli stocks from their emerging markets investments last quarter, according to Bloomberg estimates. Funds focusing on mature economies have been slow to buy the shares because Israel accounts for just 0.4 percent of the developed markets index, compared with about 3 percent of MSCI”s emerging markets measure.

“Israeli stocks might be in no-man”s land for a while,” John Derrick, the director of research at San Antonio-based U.S. Global Investors Inc., said in an interview. “It”s small enough in the developed market index to avoid altogether,” said Derrick, whose firm”s Global Emerging Markets Fund sold 9,346 shares of Israel Chemical Ltd. during the second quarter, according to data compiled by Bloomberg.

The sales have hurt returns of Israeli stocks, with the Tel Aviv 25 Index trailing the MSCI Emerging Markets Index and the MSCI EAFE index of developed non-U.S. markets since it was upgraded on May 27. Derrick said the country may attract new funds after a transition period because it has stronger economic growth than other developed markets.

Harvard Campaign

The MSCI upgrade, a plan made public more than a year ago, reflects diminished concern by investors over geopolitical risks when buying Israeli stocks, according to Frank Nielsen, an executive director for the New York-based company. Israel had already satisfied developed market criteria related to economic sustainability, market size and liquidity, and market accessibility.

None of the asset managers said they sold the shares for political reasons. In 2002, professors and students from Harvard and the neighboring Massachusetts Institute of Technology called on the schools to divest from Israel and from U.S. companies that sell arms to the country, to protest the occupation of Palestinian territory by Israel.

The petition, organized by academics including Nancy Kanwisher, a brain and cognitive sciences professor at MIT, was signed by 132 faculty members from both institutions, including Noam Chomsky, a linguistics and philosophy professor at MIT. Chomsky, in an e-mail, said while he supported the “general thrust” of the petition, he criticized it for excluding “countries with far worse criminal records,” including the U.S.

“Anti-Semitic”

The Tel Aviv 25 index returned 2.5 percent in the year after the petition, compared with a 15 percent decline by the MSCI Emerging Markets Index. In the eight years since the petition was announced and before Israel”s promotion, the gauge returned an annual average of 14 percent, excluding dividends, beating the 13 percent average of the MSCI Emerging Markets Index.

Larry Summers, Harvard”s president at that time, denounced the campaign as “anti-Semitic” and didn”t change the school”s investment policy. The sales in the second quarter reflect the change to the MSCI emerging markets index and don”t represent a divestment from Israel, John Longbrake, a spokesman for Harvard in Cambridge, Massachusetts, said in an Aug. 16 e-mail.

Harvard manages a portion of its $26 billion endowment in- house, including emerging markets investments, which it picks using the composition of the MSCI index as a guideline. External firms oversee most of the endowment. Harvard continues to invest in Israel through those managers, Longbrake said.

Greece”s Example

The school sold a $31 million stake in Teva Pharmaceutical Industries Ltd., the world”s biggest maker of generic drugs, and a $3.6 million holding in computer-software company Check Point Software Technologies Ltd. Harvard also sold $2.8 million of an exchange-traded fund that tracks Israel”s market, according to an Aug. 13 filing with the U.S. Securities and Exchange Commission.

Israel was MSCI”s first upgrade since Greece was moved up in 2001. The Athens Stock Exchange General Index lagged behind the Stoxx Europe 600 Index by 8 percentage points in the 12 months following the promotion on May 31 that year.

Citigroup Inc. estimated in March that $2.8 billion from index-tracking funds would pull out when Israel was reclassified and $3.6 billion would eventually enter. Global funds may use MSCI”s classification as a guide for where to invest, although they are not always required to duplicate the company”s weightings.

Lagging Behind

The Tel Aviv 25 Index climbed 2.8 percent from May 27, when Israel was added to the developed-market measure, through Aug. 31, trailing the 7.3 percent increase in the MSCI Emerging Markets Index and the 4.9 percent advance by the MSCI EAFE index during the same period.

Derrick said his firm hasn”t added any Israeli stocks through funds that can invest in developed-market shares, citing “short-term technical issues” as the local market adjusts to the impact of the upgrade.

Gonzalo Pangaro, manager of T. Rowe Price”s $4.5 billion Emerging Markets Stock Fund, dumped his $45.8 million holding in Teva and a $24 million stake in Israel Chemicals Ltd. in the second quarter, according to Bloomberg data.

The moves were a direct result of the MSCI promotion, Heather McDonold, a spokeswoman for the firm, said in a telephone interview.

T. Rowe, Eaton Vance

T. Rowe”s funds that invest in developed markets hadn”t reported any new purchases of Israeli stocks since the change, McDonold said.

“Just because a country or company becomes part of a fund”s opportunity set, doesn”t mean the manager will automatically buy,” she said.

Eaton Vance Corp.”s $2.04 billion Tax-Managed Emerging Markets Fund dropped all its Israeli holdings — shares in 30 companies worth $34 million — in the second quarter, according to data compiled by Bloomberg.

The fund, along with a pool of about $4.5 billion managed in a similar strategy for institutional clients, is barred by its own rules from investing in countries designated as “developed,” said Brian Dillon, institutional portfolio manager for Parametric Portfolio Associates, a majority-owned subsidiary of Boston-based Eaton Vance that runs the fund.

Mandate to Sell

“When Israel graduated, it essentially mandated that we sell,” Dillon said in a telephone interview.

At Vanguard Group Inc., the Valley Forge, Pennsylvania- based firm best known for its index-tracking funds, the managers sold Israeli stocks they held through the Vanguard Emerging Markets Stock Index Fund and bought them through the Vanguard Developed Markets Index Fund.

Institutional investors that sold Israel shares in the second quarter include New Jersey”s pension plan, which sold $1.5 million of shares in Check Point Software and $1.5 million of Cellcom Israel Ltd., Israel”s largest mobile-phone operator. One of the sales was related to the change in the index, said Andrew Pratt, a spokesman for the pension fund. He declined to give details.

The $68.7 billion Ohio Public Employees Retirement System shed $3.5 million of Teva shares. Julie Graham-Price, a spokeswoman for OPERS, said the upgrade of Israel to developed market shouldn”t change overall holdings in that country because the fund invests in both developed and emerging markets. OPERS has no specific investment policies regarding Israel, she said.

“Resilient Market”

The stock-market prospects over the next five to 10 years are promising in Israel because of the nation”s economic growth and because of its strength in the faster-growing technology and health-care industries, U.S. Global”s Derrick said. The firm, through other portfolios, may consider Israeli stocks as the country works through some of its “near-term” issues, he said.

“It has historically been a resilient market with strong underlying fundamentals,” he said.

Israeli economic growth unexpectedly accelerated to an annualized 4.7 percent in the second quarter, the fastest pace in more than two years, as exports and consumer spending increased, the Jerusalem-based Central Bureau of Statistics said Aug. 16. The median forecast of six economists surveyed by Bloomberg was for growth of 2.9 percent.

Adi Scop, a financial services stocks analyst for Israel Brokerage & Investments Ltd. in Tel Aviv, said he believes Israeli companies will recapture the lost investments. Israeli banks like Bank Hapoalim BM and Bank Leumi Le-Israel BM had little money in securitization markets overseas and thus emerged from the 2008 financial crisis with almost no damage. Financial stocks make up 24 percent of the Tel Aviv 25.

“It”s only natural that you”d see the outflows first” after the change in classification, he said. “I know there is huge interest in the larger banks from major institutional investors in Europe and Japan, but it takes a bit more time until the cash flows back in.”

To contact the reporters on this story: Sree Vidya Bhaktavatsalam in Boston at sbhaktavatsa[at]bloomberg.net; Christopher Condon in Boston at ccondon4[at]bloomberg.net; Gillian Wee in New York at gwee3[at]bloomberg.net.