Point of View

The international credit crisis and global economic slowdown of 2008 have revealed, more starkly than ever before, the extent of the linkages between the global markets. As governments rushed to rescue banks (and the larger financial system), and market conditions deteriorated, global correlations tightened significantly across all asset classes, including emerging markets and small-capitalization equities, due to international investors’ risk-averse behavior.

Despite increased correlations in the short term, sophisticated investors with long time horizons continue to evaluate and expand their international exposure. Greg Behar, investment strategist, Northern Trust global quantitative index management group, explains that many of the firm’s institutional clients are broadening and deepening their international exposure by increasing investments in developed international small-cap equities, emerging markets and frontier markets. “Investors with a true long-term perspective should not be deterred from evolving their allocations to include the complete international equity opportunity set and rebalancing to their targets,” Behar says. As part of this continued shift toward global investing, a new focus on “frontier markets,” which have historically offered a promising risk/return ratio and strong diversification benefits, has emerged.

The Big Picture

Foreign countries comprise a large and growing component of the global economy and investment markets. Non-U.S. markets make up 54% of total global market capitalization, 95% of the world’s population and 79% of world economic output as measured through gross domestic product (GDP). Of course, these international stock markets are far from homogenous. Just as the U.S. stock market has many segments and sectors, so do international markets. Just as the S&P 500 Index doesn’t capture the performance of many U.S. small-cap equities, the MSCI EAFE Index (the benchmark frequently used as a proxy for developed international equities) is not a comprehensive measure of non-U.S. equities.

The EAFE Index covered 69% of all international investment opportunities at the end of 2008, primarily reflecting large-cap stocks in developed markets. Asset classes such as developed market small-cap stocks, emerging markets, emerging market small-caps and frontier markets constitute the remainder of the international equity opportunity set. Thanks to recent changes by benchmark index providers, it is now easier to accurately replicate the entire international stock opportunity set including the relatively untapped frontier markets.

What are Frontier Markets?

“Frontier markets are the next generation of emerging markets,” Behar says. “These markets tend to be developing countries with high rates of economic growth and small, relatively illiquid equity markets.” For example, the average annual GDP growth rates in 2007 were 3.40% for developed markets, 6.12% for emerging markets and 6.70% for frontier markets.

“Overall, frontier market countries have low correlations with each other and with major global indices,” says Shaun Murphy, senior portfolio manager, Northern Trust global quantitative index management group. “They tend to be underequitized, undercapitalized and often are rapidly building their infrastructure.” That provides plenty of growth potential for each country’s economy, he explains. The median stock market capitalization of frontier market economies is 24% of GDP, compared with almost 50% for emerging markets and more than 88% for developed markets. This underscores the growth potential of frontier markets.

Why Invest in Frontier Markets?

There are three reasons for the increased interest in frontier markets among institutional investors: maximum global investment exposure, low correlations and superior growth potential.

Because frontier markets make up about 1% of the entire international equity universe, they might be the final piece added by many investors seeking a broad international diversification strategy. Murphy cautions that investors interested in frontier markets should aim for an extremely broad exposure. “Investing in frontier markets requires a strategy where you obtain broad diversification,” he says. “You should have exposure to many different frontier market economies, countries and regions.”

The events of 2008 have underscored the need for — and value of — a diversified international and emerging markets exposure, and frontier markets can play an important role in a globally diversified portfolio due to their very low correlations with developed equity markets. Many emerging market investors in the recent past focused on concentrated allocations to countries such as Brazil, Russia, India and China (BRIC), a strategy that proved ineffective during the market turmoil. During the past year, investors holding a concentrated position in the BRICs would have underperformed those holding a broad emerging markets exposure. Furthermore, investors who expanded their emerging market exposure to include frontier markets outperformed both BRIC countries and the broader emerging markets.

In the 1990s, the S&P 500 Index and the MSCI EAFE Index had a moderately low correlation of 0.54. In other words, they moved in the same direction about half the time. However, from January 2000 to December 2008, the correlation between the two indices rose to 0.86. The “Increased Levels of Correlation” table shown below conveys the high correlations so far this decade, not only between the S&P 500 and MSCI EAFE indices, but also between each of them and global equity sub-asset classes such as emerging markets, developed international small-cap and emerging market small-cap stocks.

Although the correlation between frontier and developed markets has tightened in recent months, it remains low in comparison to other asset classes with the S&P Extended Frontier 150 exhibiting a correlation of 56% with the S&P 500 between January 2005 and December 2008. This low correlation demonstrates that these markets move in a common direction only 56% of the time, a stark contrast to the 75% to 95% correlations exhibited by other developed markets. These correlations underscore the strong long-term diversification potential that frontier markets offer.

Frontier markets are in their infancy. Thus, many investors are considering frontier markets for their growth potential as they have similar characteristics to those of emerging markets in the early 1990s. The weight of frontier markets in today’s international market is currently at 1%, where emerging markets were in 1988. Some investors argue that the frontier markets are even more attractive as their GDP per capita is significantly higher today than the GDP per capita of emerging markets in the 1990s.

Since the beginning of this decade, the risk/return profile (as measured by standard deviation of returns) of frontier market equities has been attractive, as shown in the “Equity Risk/Return Characteristics” chart below. Many investors are surprised at first by the historically low standard deviation of frontier markets. Behar cautions that individual country volatility can be much higher and that the low correlations between different frontier markets may be a contributor to the overall low standard deviations of the asset class. Hence, he says that a diversified approach is the best strategy. Behar also believes that the lower volatility of frontier markets may be driven by the slow adjustment of prices in these markets due to a combination of low liquidity and the long-term investment horizon of investors in these asset classes.

Addressing Potential Risks

Risks are part and parcel of any investment, but investors in less-developed international markets face additional risks due to a lack of the infrastructure and safeguards that investors are accustomed to in established markets. While substantial risks exist in frontier markets, they are not insurmountable for investors who understand the risks and are willing to conduct the additional due diligence required to invest in these markets.

Operational risks: These include any elements that could impede the operational aspects of buying and selling securities in a local market. This encompasses potential for settlement issues, including failed trades and high overdraft rates. “Botswana is one country that has heightened operational risks,” Behar notes. “Its processes are highly manual, and it doesn’t have delivery vs. payment, which means that securities and cash aren’t handled at the same time, an additional risk.”

Regulatory/market risks: Each market may have its own set of regulatory risks or other market barriers. These could include high regulatory barriers to entry into or exit from the market, currency restrictions, onerous local custody account setup and maintenance and/or limits on foreign ownership.

In several cases, previously existing regulatory or other barriers have been removed. For instance, the United Arab Emirates (UAE) and Vietnam recently raised their limits on foreign ownership of equities in their respective countries. Earlier this year, Kuwait significantly reduced its 55% capital gains tax on foreign investors. Although many frontier markets have made significant reforms, there is clearly more to be done. For example, Lebanon’s currency regulations, which don’t allow foreign investors to hold local currency balances overnight, continue to present a prohibitive barrier, although the country can also be accessed through depository receipts.

Transaction costs: Investors should always be aware of investment-related expenses including transaction costs. Frontier markets by nature are more costly to invest in due to factors such as higher commissions, fees and taxes, wider spreads and lower liquidity than in more established developed markets.

Geo-political risks: Frontier market countries may face heightened geo-political risk. In particular, investors need to consider how geo-political conditions affect market accessibility and operational and regulatory characteristics.

Integrating Frontier Markets into a Global Portfolio

The increasing linkage between the world’s developed and emerging markets has underscored the need for further sources of diversification, something that frontier markets may offer in the long term. Despite the significant risks discussed above, some investors believe frontier market countries may follow the growth trajectory of successful emerging market countries. Furthermore, as global portfolio flows to frontier markets grow, some of the risks of these markets may diminish as liquidity improves and governments respond to investor interest with continued market reforms. Investors with a current allocation to emerging markets and an appreciation of the potential risks might consider a proportional allocation to frontier markets.

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