Just as our cosmos is continuously expanding, so it seems is the equity index universe and the tools for targeting desired exposures. One recent development that is gaining traction with investors is frontier or “pre-emerging” markets. Some early adopters have expanded their own equity investment space and enhanced their equity portfolios’ risk-adjusted returns by diversifying into frontier markets.
The case for investing in frontier markets today is a lot like the case for investing in emerging markets 15 or 20 years ago. With frontier markets, investors gain exposure to a secular growth story in parts of the world that are not represented in even the broadest global benchmarks, such as the MSCI All Country World Index, including the Middle East, Eastern Europe and Africa.
Because frontier markets are much smaller on a global market-cap basis, investors may enjoy a first-mover advantage unlikely to exist elsewhere in the world of equities. And thanks to sounder fiscal policies, coupled with the International Monetary Fund’s more proactive approach in aiding countries experiencing economic turmoil, frontier markets today have a more robust safety net than did emerging markets in the 1980s.
While the opportunity to make an early-stage investment with attractive long-term growth potential is certainly piquing a lot of interest, frontier markets are also appealing because of their relatively low correlations with the rest of the equity universe. We see a real opportunity to diversify an equity portfolio with an allocation to frontier markets. And let’s face it, there aren’t many diversifying asset classes anymore.
Add in the fact that they trade at relatively low price-to-earnings ratios while offering exposure to some booming economies with potentially faster growth rates and the rationale for adding frontier exposure to an equity portfolio looks even more compelling.
Finding efficient exposure
Some investors may have already given leeway to their current emerging market manager(s) to invest in frontier markets. Although a step in the right direction, this in itself will not give an investor the full benefits of frontier markets as the exposure will usually not be meaningful enough.
Investors can gain initial exposure through index funds. Indexing for frontier exposure has two big advantages.
First, it would be difficult to find an active fund manager with expertise in, for example, both Kenya and Kuwait. So when faced with the otherwise daunting task of implementing a portfolio that covers 23 diverse countries ranging from sub-Saharan Africa to Southeast Asia and beyond, indexing quickly emerges as an easy first step and efficient choice.
Second, while some may still be tempted to pursue active management in these underexplored markets, the transaction cost is so high that it can erode any active insights a manager may have.
Low correlations reduce volatility
While it’s no great surprise that these less-liquid markets exhibit high transaction costs that limit the opportunity for alpha, it may seem counterintuitive that frontier markets are actually less volatile than emerging markets. On a stand-alone basis, individual country volatility is indeed higher in frontier markets. But taken as a whole (as is the case when investing in a broadly diversified index), the frontier universe demonstrates lower overall volatility.
A closer look reveals that frontier markets provide exposure to a diverse set of countries and companies in which returns are driven locally as opposed to globally. In other words, frontier markets investors can purchase a basket of assets—ranging from a Vietnamese dairy company to an Estonian ferry operator—that exhibit very low correlations with one another.
The volatility is lower than in emerging on account of low intra-market correlations within frontier. Because what goes on in Vietnam has little to do with what’s happening in Estonia. Contrast this with emerging markets where China has become Brazil’s biggest economic partner—with trade between these two developing giants approaching US$100 billion annually, according to World Trade Organization data—and frontier markets’ lower volatility isn’t so shocking after all.
Average intra-market correlation for frontier countries was only 0.4 over the past five years, compared with 0.8 for developed and 0.7 for emerging markets, according to MSCI. Low intra-market correlation also exists at the regional level. Africa, for example, has a large exposure to consumer staples, while the Middle East is concentrated in financials and telecommunication.
For investors who want even more diversified exposure (and potentially lower risk), many indices can be capped so that a country cannot exceed 15% of the total allocation.
The next big bang
Few might have predicted that indexing would grow to encompass markets such as Kazakhstan and Nigeria, or that quantitatively designed, volatility-dampening indices would find a place alongside traditional cap-weighted benchmarks.
While it may be equally difficult to divine what the future holds, one thing seems clear: investors would be well served to keep abreast of the latest developments, as the inexorable march of the beta universe carries on.