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Frontier markets represent a tiny segment of the
global investment universe, but interest in the asset
class has been growing as investors search further
afield for better growth opportunities and pursue new
ways to diversify their portfolios.
Frontier markets, by definition, are at the far edge of
the investment universe and are generally not
included in global-equity indexes or in most emerging-
markets equity funds. This is because frontier capital
markets are not easily accessible. These markets
tend to have a small number of liquid securities and
restrictions on foreign ownership. Investors mulling
the merits of this investment frontier should take
a closer look before jumping in: The underlying risks
and performance drivers are quite different from
those in emerging and developed equity markets.
Surveying the Frontier
The frontier-markets universe is typically composed of
stocks listed in Africa, the Middle East, former
Soviet Republics, and less-developed Asian countries
such as Pakistan, Vietnam, and Bangladesh. The
investment case for these countries is enticing—
many are entering a period of mid- to high-single-digit
growth, thanks to a very low economic base, favor-
able demographics, growth in infrastructure spending,
and, in some cases, abundant natural resources.
In addition, some countries will benefit from the
rapid adoption and dissemination of “new economy”
services such as mobile banking and mobile payments.
The risks of investing in frontier markets are many,
including political instability, social unrest, corruption,
disease, terrorism, underdeveloped financial
systems and capital markets, and a fickle regulatory
environment. Most importantly, during periods
of extreme market stress, frontier markets’ relatively
illiquid stock markets can suffer sharp declines in
the face of heavy selling. During the
2008
global
financial crisis, the
MSCI
Frontier Markets Index had
a maximum drawdown of
66%
, greater than the
MSCI
Emerging Markets Index’s
58%
. Recent declines
in commodity prices may prompt selling pressure
in frontier markets, as many countries in the Middle
East and Africa are commodity exporters.
But when looking at other measures of risk, frontier
markets tend to fare better. Partly because of lower
levels of integration with the global economy, each
frontier-markets country tends to have more idiosyn-
cratic risks, with individual equity markets historically
exhibiting low correlations with one another.
As a result, the
MSCI
Frontier Markets Index has
been less volatile (as measured by the rolling
three-year annualized standard deviation of returns)
than the
MSCI
Emerging Markets Index.
As for diversification benefits, frontier markets
have been less correlated to U.S. equities relative
to emerging markets.
Recent Performance
One reason frontier-markets equities are gaining
interest is their outperformance versus emerging
markets in the past couple of years. This is
often attributed to frontier markets’ rosier growth
outlook relative to emerging markets, especially
as the larger economies such as China, Brazil, and
Russia have begun to slow.
However, a closer look reveals that frontier markets’
recent performance reflects a confluence of factors—
some fundamental, some not, and many that are
specific to frontier-markets equities. An examination
of some of these factors will help illustrate the
notable idiosyncrasies and challenges related to
investing in frontier markets.
During the past two years, the best-performing frontier
markets have been United Arab Emirates, Argentina,
and Kenya. The capitalization-weighted
MSCI
indexes
(in U.S. dollars) for each of these countries returned
47%
,
41%
, and
35%
, respectively, for the two-year
period (annualized) through December
2014
. These
returns contributed to the
MSCI
Frontier
Frontier Markets Begin to Emerge
Morningstar Research
|
Patricia Oey