By Joseph Hogue, CFA
Having been a resident of Medellin, Colombia for some years, I always wondered at the naming convention for developed, emerging, and frontier markets. Medellin is a vibrant city about the size of St. Louis, and considered by many to be the fashion capital of Latin America. While living there, I never lacked for access to technology or social services, and the city’s train system beats any I have seen in the U.S. hands down. Of course, leaving the city validates the country’s emerging or frontier status among capital markets.
Of the 117 countries with independent stock markets, MSCI places 24 in the developed category and 22 within emerging status. GDP per capita in the developed markets tends to be around $23,000 or more, while the emerging markets tend to have per capita GDP of between $800 to $23,000 using purchasing power parity measures. The MSCI Frontier Markets Index includes 31 countries and selects countries through a liquidity screen and minimum size requirements. The index had a market capitalization of $228 billion across approximately 371 constituents as of 2010.
Though countries around the world are included in frontier market funds, the five frontier regions all have unique opportunities and challenges providing for a high level of diversification and growth when combined in a portfolio. I do not necessarily recommend frontier markets as return enhancers over emerging market investments. The benefit to frontier market investment is in the increased diversification. Emerging markets, through their integration with world commerce, are becoming more correlated with the developed market indices. Though many of the emerging markets may not be as susceptible to market declines in the event of a U.S. recession, a view I backed up with data from the World Bank in a previous article, they are still more correlated with the developed markets than are the frontier regions. Frontier markets, by virtue of being less integrated, have provided a greater amount of diversification even during times of increased volatility. Frontier markets account for about a fifth of the world’s population but only six percent of nominal GDP, so portfolio exposure to these markets does not need to be a sizeable position.
The table below shows the correlation of returns between four frontier market ETFs, two emerging market ETFs, and the Select S&P500 (SPY) for July 2008 to September 2011. While emerging markets might provide good diversification to developed markets most of the time, the last few years saw an increase in their correlations.
Of importance to investors is not so much the naming conventions, but which countries are included in the most liquid funds and which provide the most appropriate allocation to frontier market exposure.
The Guggenheim Frontier Markets (FRN) seeks to replicate the results, before fees and expenses, of the BNY New Frontier Index and invests at least 80% of total assets in ADRs and GDRs trading on developed exchanges. The fund holds 44 companies with country exposure in Chile (37.0%), Colombia (14.4%), Argentina (10.7%), Egypt (9.9%), Peru (4.6%), Kazakhstan (4.4%), Lebanon (3.5%), Nigeria (3.3%), and Poland (2.4%). The fund is heavily concentrated in three sectors: Financials (33.8%), energy (18.6%), and utilities (14.0%). Securities held in the fund have an average market capitalization of $7.7 billion and an average price to book of 1.9 times. Investors may want to consider a combination of funds for frontier exposure. The FRN holds two-thirds of the fund in Latin American markets with marginal exposure to Northern Africa and Eastern Europe. A combination of the FRN and either the AFK or PMNA would provide a more globally-diversified portfolio of frontier markets.
The SPDR S&P Emerging Middle East & Africa (GAF) tracks the S&P Mid-East and Africa BMI index. The fund holds 139 companies with country exposure in South Africa (89.3%), Egypt (5.3%), and Morocco (4.9%). More than two-thirds of the fund is held in three sectors: Financials (28.5%), materials (23.6%), and consumer discretionary (14.2%). Holdings have a weighted average market cap of $12.7 billion and an average P/B of 2.2 times. Though the fund may fit with investors seeking exposure to South Africa, I do not consider it a diversified country fund. Investors looking for diversified exposure to Middle East and Africa would probably prefer the PMNA or the AFK funds.
The Market Vectors Africa Index seeks to replicate, before fees, the performance of the Dow Jones Africa Titans 50 Index. The fund holds 51 securities in South Africa (25.8%), Nigeria (18.5%), Egypt (16.8%), Morocco (11.9%), and a 25.5% in companies headquartered outside of Africa but generating a majority of revenues from the continent. The fund is marginally more diversified across sectors holding large weights in four groups: Financials (40.0%), materials (19.1%), energy (13.4%), and telecom services (13.3%). Holdings in the fund have an average weighted market cap of $10.7 billion and an average P/B of 3.4 times as of June. Investors face something of a challenge with Africa exposure. The GAF is basically a South Africa fund and is fairly highly correlated with the developed market index. While the AFK provides a more diversified exposure to the African region and a much lower correlation with the S&P500, it has underperformed both the developed index and the GAF substantially over the last three years. Much of the underperformance is from the exposure to North African countries, specifically Egypt, whose markets have fallen due to social unrest.
The PowerShares MENA Frontier Countries tracks the Nasdaq OMX Middle East North Africa Index and invests at least 90% of assets in ADRs and GDRs based on the securities in the index. The fund holds 43 companies with country exposure in Qatar (22.2%), Kuwait (19.4%), Egypt (18.3%), United Arab Emr (17.6%), Morocco (9.7%), Jordan (7.5%), and Lebanon (2.6%). The majority (68.3%) of the fund is held in financials, with telecom services and industrials comprising 13.9% and 11.5% respectively. Holdings have an average market cap of $8.2 billion and a P/B of 1.4 times.
Comparing these with the iShares MSCI Emerging Markets Index (EEM) is useful. The fund holds 853 companies with a more diverse selection of countries and regions including: China (16.9%), South Korea (15.0%), Brazil (14.8%), Taiwan (10.9%), South Africa (7.4%), Russia (7.1%), India (7.0%), Mexico (4.3%), Malaysia (3.3%), and Indonesia (2.8%). Sector diversification is also more widespread, with financials (24.1%), energy (14.7%), materials (14.6%), and information services (11.9%) representing the largest holdings. The average market capitalization for the companies in the fund is $34.5 billion and has an average price to book of 3.1 times.
The lack of sector diversification within the frontier funds when compared to emerging is partly due to the lesser extent of economic diversification among frontier markets. This, along with increased political and social instability, is the primary drawback to frontier markets. Their rising status is often a result of performance within one or two particular industries, often mining and energy-related industries. For strong growth to continue and a possible graduation to emerging status, the country must diversify its own economy and build a competitive position in other industries. Though I believe U.S. investors should hold at least half or more of their portfolio in internationally-based equities, the proportion in frontier markets should be relatively small. Within the equity portion of the portfolio, a weighting of 5-10% in frontier markets and 15-20% in emerging markets would be more than enough for most investors of average risk tolerance. Investors must choose their funds wisely. In a previous article, I found that the effect of a U.S. and European recession on the emerging markets would not be uniform across regions. Within emerging markets, investors may be able to go with country specific funds given greater transparency. In frontier market investments, however, investors should stick with country-diversified funds to minimize country or regional events.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.