Frontier Markets: An ‘Emerging’ Asset Class?
When MSCI established its emerging markets index in 1988, this newly formed asset class represented approximately 1% of the world equity investment opportunities. Today, emerging markets represents 22% of the world equity markets and is on track to become 39% of this market by 2030.
Though EM was a new (and somewhat scary) asset class when it began to gain traction in the late 80s, early adopters sought (and experienced) significant benefits:
- Higher returns
- Uncorrelated returns
- Low intra-market correlation between EM countries
Since the late ’80s, EM has delivered on all three of these benefits, especially higher returns. Between 1988 and 2013, EM had a total return of 1,776%, compared with the S&P 500 Index’s total return of 1,242%. Although EM had a low correlation with U.S. equities in the early ’90s (approximately 0.40), correlations have steadily increased and stand close to 0.85 today. Intra-market correlations have also risen as large EM countries such as China have reached the point where its performance significantly impacts (good or bad) other countries with which it has strong economic ties.
In fact, EM has changed so much over time that many investment experts are beginning to question whether “emerging markets are the next developed markets,” which is the title of a BlackRock paper written in August 2011. This paper concluded that:
As emerging market economies have grown and converged with their more developed counterparts, the long-time — and much trumpeted — EM diversification benefit for investors has, in our view, somewhat abated. We believe that diversification in itself no longer provides an adequate justification for investing in emerging markets.
In spite of the changing dynamics of EM, the BlackRock report still considers that “emerging markets’ share of world financial assets will increase materially over the next decade both through price appreciation and capital issuance.” The point is that while EM is less favorable as a source of diversification, it remains a good source of growth.
Just as EM has materialized as a major asset class over the last 25 years or so, frontier markets (FM) — those countries that are not sufficiently developed to be included in the emerging markets index — now resembles what EM looked like in the late ’80s. Like EM in the early days, FM is very small compared with the rest of the world’s equity markets. Although it is difficult to say precisely the size of FM relative to other worldwide investable opportunities, it is generally believed to be less than 1%, which is similar to where EM was in the late ’80s.
An excellent overview of frontier markets can be found in a paper published by FTSE, “Frontier markets: Accessing the Next Frontier.” (FTSE — along with S&P and MSCI — has developed its own FM index.)
The FTSE paper discusses four primary advantages of frontier markets:
- Attractive economic fundamentals
- Lower volatility than perceived
- Valuations remain relatively low
According to the paper, the “economic fundamentals” are rooted in higher growth rates, favorable demographics, a strong fiscal position and “rapid urbanization and technological advances, coupled with lower labor costs make Frontier Markets attractive destinations for manufacturing hubs.”
In terms of volatility, when someone hears the names of the countries in the FM index such as Pakistan, Nigeria and Bangladesh, the assumption is that FM must be highly volatile. However, as the FTSE paper demonstrates, FM volatility over a recent three-year period has proved to be “noticeably lower than that of both developed and emerging markets.” According to the report, FM is about 50% less volatile than developed markets and nearly 100% lower than emerging markets, which the FTSE report attributes to FM’s “less volatile currencies and low-cross country correlation.”
The benefits of increased diversification lie in the low correlation of the frontier markets with both the developed and emerging markets. As reported in the FTSE paper, “the 5 year correlation of the FTSE Frontier Index with the FTSE Developed All Cap and Emerging All Cap indices remain relatively low at 0.58 and 0.52 respectively as of June 30th 2014.”
Finally, the FM valuations are trading at about a 20% discount to emerging markets, which is trading at a 40% discount to U.S. equities. Given the fact that many would argue that valuations are the best indicator of future performance, FM valuations are compelling at a time when many feel that the developed markets’ valuations are becoming increasingly “stretched.”
Just as emerging markets delivered significant returns and diversification benefits from the late ’80s — benefits that have diminished (but not disappeared) over time — so it may be the case that frontier markets offer a similar opportunity to fill that investment need today. However, it should be noted that, although FM’s volatility looks to have been historically low in comparison to EM and DM, this could very well change in the future. Perhaps of greater concern than disruptive geopolitical events (EM prospered through many bad world events) is whether or not this asset class could quickly become overbought. In a recent Pension and Investments article, “Frontier Markets Move Slowly onto Investors' Radar,” a CIO was quoted as saying that, “If an investor is looking to put $100 million to work, it's difficult not to be the market.” That a market can be moved with a $100MM investment should be a cause for concern. Any large movement of assets into (or out of) FM could create some significant volatility.
From a plan advisor perspective, it would not be a good idea to offer FM as a stand-alone option in a DC fund lineup. There is too little history and the asset class is too small, making it difficult to clearly understand the potential for volatility.
With the U.S. market going a bit sideways and with emerging markets tied largely to U.S. performance, it is tempting to search out riskier assets with a low correlation to the rest of the world and with room to grow. However, FM does not seem to be ready for prime time as it relates to individual DC investor choice. It may ultimately prove to be an attractive asset class; however, there is not enough history to say that it is a prudent choice today.
It should also be noted that in the case of a number of EM funds (e.g., Templeton Emerging Markets Fund), frontier countries are already being included in the investment mix. Thus, some investors invested in EM funds are also experiencing exposure to FM.
Where FM would seem to make the most sense is being imbedded in an asset allocation construct managed by a professional money manager, such as a target-date fund. Used in small doses along with other alternative type vehicles, FM could very well add diversification and return benefits.
Just as the emerging market asset class was once a somewhat obscure asset class, drawing little attention compared to developed markets, so it may be with frontier markets. For sophisticated individual investors who know what they are getting themselves into, investing in frontier markets could create a first-mover advantage. That said, it would be important to keep an eye on an asset class that could go quickly from having an attractive valuation to being overbought, thus becoming less desirable from an ownership standpoint. This is why allocating to frontier markets requires the expert oversight of a professional money manager.