Investors were once able to diversify portfolios by adding emerging market stocks to the mix. However, emerging stock markets have been trading more or less in lock step with developed stock markets over the latest global economic cycle. The correlation of the MSCI World Equity Index and the MSCI Emerging Markets Index has risen to above 0.90 over the past five years from just above 0.80 during the previous five (1.00 is perfect correlation). These historically high correlations are likely a result of central bank policy spearheaded by Alan Greenspan and Ben Bernanke. This begs the question: What strategies can investors use to create optimal portfolios? The answer could lie within the “Frontier Markets” universe. Frontier markets are considered a sub-set of emerging markets, which are investable but have lower market capitalization and liquidity than emerging markets. Countries in the MSCI Frontier Emerging Market Index include Argentina, Ghana, Vietnam, and Lebanon. While the correlation among developed and frontier markets has risen over the past business cycle, the correlation from 2002 to 2007 between the MSCI World Equity Index and the MSCI Frontier Emerging Markets Index was around 0.50. The MSCI Frontier Emerging Markets Index didn’t exist in the early 1990s.
Aside from the diversification benefits, frontier markets offer substantial opportunities. The International Monetary Fund expects significantly greater economic growth in emerging and frontier economies than in developed economies. Furthermore, this expected growth comes without the enormous debt loads and fiscal troubles that are plaguing most developed economies. Standards of living and health are on the rise in many frontier economies, and will drive economic development. The lower the per capita income, the greater the potential is for growth. Demographics in frontier economics are also favorable relative to developed economies. Developing countries tend to have a greater population of young people and production will surely shift to where the hardworking people live. This will likely result in a rising middle class with appetites for food, energy, financial services, and electronics.
Investing in frontier markets can be challenging. Stocks in frontier markets are generally driven by local dynamics as opposed to foreign institutional investors, resulting in lower trading volumes. Additionally, there are more inefficiencies in frontier markets, although at times inefficiencies can translate into profitable investment opportunities. Frontier market stocks are cheaper than developed markets. The price-to-earnings ratio for the MSCI Frontier Emerging Markets Index is currently 12.75, while this ratio for the MSCI World Equity is around 14.75. The dividend yield is also higher in frontier markets. However, companies in frontier economics may lack good governance practices, making careful company research a must. In summary, where there are potential opportunities for enhanced return, there are often increased risks to navigate.
Tony is Senior Portfolio Manager with Portfolio 21 Investments. He has 15 years of experience in the field of investment management.