posted on October 25, 2016 16:33
Just as promises of gold drew prospectors of the 1800s westward, the potential for higher expected returns attracts investors to the frontier markets. While the challenges differ, investors on this frontier should not brush aside the lack of liquidity or region concentration. With this in mind, utilizing a strategy that dampens the costs and risks while providing an exposure to fast-growing frontier markets (“the new emerging markets”) could provide an allocation to frontier markets that can be markedly beneficial to a diversified portfolio.
Why Invest in Frontier Markets?
Assembled by the MSCI Frontier Markets Investable Market Index (MSCI FM IMI), the 23 frontier markets are defined as smaller, less developed economies. These markets can potentially provide superior returns to more developed markets over longer time horizons. This increased expected return comes as a result of greater risk and an expectation of higher economic growth in these developing regions.
Individually, frontier market countries can be volatile, but due to their lack of correlation, the risk (standard deviation) is diminished when combined as an index. Figure 1 illustrates that the risk of frontier markets is lower than that of the aggregate world stock markets (MSCI ACWI ex USA Index). Furthermore, the frontier markets index has lower risk than some of the individual country components of the frontier markets, such as Kenya, Bahrain, Estonia, and Pakistan. This lack of correlation with developed economies creates an additional diversification benefit to investors who include frontier markets in their stock portfolio. These imperfect correlations, along with higher long-term expected returns, make frontier markets very appealing to investors.
Much of the investable frontier markets are concentrated in only a handful of countries. Businesses from Kuwait, Argentina, Pakistan, Morocco, and Nigeria constitute approximately 55% of the index, adding to the challenge of building a diversified frontier markets allocation. Furthermore, the index constituents (see Figure 2) are generally small companies as evidenced by the 0.3% market share of world stock markets. In fact, as of July, 37 individual firms in the S&P 500 had a greater market capitalization than the entire frontier markets index! This presents challenges to portfolio managers.
This challenge can be tackled by utilizing an emerging markets fund that divides the emerging and frontier markets into tiers. Within each of these tiers, the allocation to each country is the same weight so that no single country dominates the fund’s return profile. By including frontier markets as the smallest tier in this emerging markets fund, the fund can overcome illiquidity and higher costs that are generally associated with frontier markets. This approach allows the fund to efficiently allocate a greater percentage of assets to frontier markets than based solely on market capitalization, increasing returns and reducing risk over time. Diversified, long-term investors should reap additional benefits from this proficient, cost effective allocation to the emerging and frontier markets which in total could represent as many as 50 countries. Contact Savant or your advisor for details regarding the specific fund(s) used in your model portfolio managed by Savant.
Sources: MSCI Inc., Morningstar Direct