The three most commonly discussed investible regions of the world are, 1) the United States, 2) non-US developed countries (which constitutes much of Europe, along with Japan, Canada, Australia, and a few others), and 3) emerging market economies (such as the “BRIC” countries — Brazil, Russia, India, and China). The market capitalization of these regions as a percent of total global capitalization is approximately 49.5% in the US, 39% in other developed markets, and 11% in emerging markets.1 The remaining .5% is primarily comprised of frontier markets — countries that have investible markets, but that are less developed than emerging markets. This Investment Product Review focuses on possibilities for investments in these “pre-emerging” countries as a component of an investment strategy.
Frontier markets include Argentina, Pakistan, Nigeria, and Vietnam, with the majority of the remaining countries in this category located in Africa, the Middle East, and Eastern Europe. As frontier markets become more developed they may progress to the emerging markets group. A recent example of movement between groupings was the promotion of Qatar and the United Arab Emirates to emerging status by MSCI Barra (effective as of June 2014). It should be noted that frontier markets do not include all countries considered to be below emerging status. There are many countries that are not considered sufficiently developed to be classified as frontier. Some examples of the sub-frontier grouping are Botswana, Jamaica, and Cambodia.
Like emerging market economies, frontier markets are expected to have growth rates significantly higher than those of developed countries. Frontier countries tend to have much younger populations as well as lower levels of education, and generally have economies based heavily on labor. These factors signify much larger potential for future growth than older, well-educated, capital-intensive developed countries. The advantage of starting from a low base (with respect to development) is that there is much room for improvement. Even small changes to the education systems, infrastructure, or availability of capital can be extremely beneficial to companies in these regions; far more so than equivalent improvements in developed countries. For example, an increase in the literacy rate of a country can give local firms access to a more skilled workforce, or improvements to the conditions of the local network of roads can drastically increase the ability of those companies to move their products, improve their supply chain, or obtain access to more consumers.
Though the relationship is far from exact, generally high long-term growth rates correspond with higher long-term equity returns, as has been the case with emerging markets over the previous decade. Because the factors affecting their respective economies are so different, frontier market returns tend to have low correlation with most other equity asset classes, particularly with those of developed markets. For example, as of July 2013, the MSCI Frontier Market Index has a 10-year correlation of 57.3% with the S&P 500 Index, and 59.9% with the MSCI Emerging Markets Index. This relatively low level of correlation means that frontier markets can provide some diversification benefits as part of a global equity portfolio. Frontier markets are often highly dependent on the export of raw materials, so their returns tend to be more closely related to commodities than do those of more developed markets.
Frontier market companies do have their own set of risks, which are somewhat different from those of many other investible asset classes. The frontier countries themselves are relatively underdeveloped, and tend to be both politically and socially volatile. The recent turmoil in Egypt (actually an emerging market as opposed to a frontier market) provides an example of this type of political risk, which is far lower (though never entirely nonexistent) in developed nations. Aside from civil war, other risks can include excessive corruption and confiscation of assets by governments, not to mention any associated currency risks. The financial markets in frontier countries also tend to be less advanced. This means that equities of frontier companies tend to be both less liquid and less transparent. The lack of liquidity can increase the difficulty of trading stocks, along with resulting in higher trading costs. Further, the lack of transparency can make auditing and due diligence more challenging. Because of the difficulties involved in managing frontier market equities, frontier funds, both passive and active, tend to have higher management costs.
At Empirical, we believe that frontier market companies are an asset class worthy of consideration, but only in certain cases. As an asset class, frontier markets provide diversification along with high expected long-term returns. However, they carry a significant number of risks, including some that do not exist in emerging markets, thus investors considering a frontier allocation must weigh the risk against the potential gains. Our recommendation is that frontier market equities should be only considered if they are among the most liquid available (i.e., the largest and most widely traded companies) and are held as part of a widely diversified basket. Currently, the index fund that best fits this description is the iShares MSCI Frontier 100 ETF, which invests in the 100 largest frontier companies (as measured by market capitalization). Even in a relatively liquid and diversified form, frontier markets should only be considered by investors with a high level of risk tolerance (as these stocks can be quite volatile at times) and with a long time horizon.