Emerging markets have been all the hype for at least three decades now. Offering higher risk and return than more established developed markets, they are a good addition to almost any equity portfolio. Obviously they are not for the faint of heart, with the MSCI Emerging Markets index returning -53% in 2008, followed by +78% in 2009. That’s simply incredible and it makes my palms a little sweaty. Last year the same index returned +37%, what’s next? But we can one-up them: frontier markets.
Frontier markets are countries that are not quite emerging yet
In the simplest sense, you could see frontier markets as lesser developed markets that are not quite at the level of emerging markets yet but may some day be. Basically the hierarchy goes from least developed markets (think Ethiopia or North Korea), to frontier markets (think Argentina or Egypt), to emerging markets (think Russia or Brazil) to developed markets (think Germany or the United States).
But that does not paint the entire picture, as which countries are exactly seen as frontier market is typically decided by equity index providers like FTSE, MSCI, S&P or Russell based on a custom set of decision rules. MSCI looks at size and liquidity requirements and market accessibility requirements:
- Size and liquidity. MSCI requires a market to have at least 2 companies that 1) have an annualised traded value ratio (ATVR) above 2.5% (ATVR is basically a ratio of how often securities trade hands, ie. how liquid they are), 2) have a market cap above $630 million and 3) have issued securities with a size above $49 million
- Market accessibility. there has to be at least some openness to foreign ownership and partial freedom of capital flows
In both cases these requirements are more stringent in the case of EM. Some smaller frontier markets that may appear not to fit in with the other ones (Slovakia and Estonia come to mind) will be included merely based on their size being small enough to not be eligible for EM indices (let alone the DM ones). Also, many frontier markets eventually “graduate” to become emerging. Per MSCI, 30 years ago today’s emerging markets formed 1% of global GDP, vs 10% today.
Classic frontier markets are Argentina, Egypt, Nigeria and Vietnam
The MSCI Frontier Markets index contains 25 countries, of which Argentina, Kuwait, Vietnam, Morocco and Nigeria are the largest. Other prominent ones are Vietnam, Kazakhstan, Ghana and Tunisia. Obviously, each of these countries have their own (often compelling) development story and one of the key attractions of frontier markets is low correlation not only with other investments but also between countries themselves.
- Argentina. One of the largest economies in Latin America, well diversified and rich in natural resources. Currently undergoing an economic transformation after years of ill-guided policies under populist leadership, though still suffering from currency depreciation and high inflation. Many are betting on this one to move on to the EM indices, which will cause even more money to flow into its market
- Egypt. Suffered from political instability following the Arab Spring, but is slowly crawling back. Scrapped currency controls in 2016 which made international finance very happy, and gained access to IMF assistance
- Nigeria. A very oil dependent economy that is fighting with islamist extremism. Went the opposite way of Egypt by imposing currency controls, however other reforms and the rebound the oil should be more promising
- Vietnam. Young demographics, rich in natural resources, increased market freedoms make Vietnam a compelling investment target
Frontier market equities are heavy in financials, tech and consumer staples
When you are investing in frontier markets you can do so through either fixed income or equity exposure. Both have a very different risk-reward tradeoff (often the interplay between interest rates and inflation becomes a thing to watch on the bond side), and here I focus my attention on building an equity portfolio. The MSCI Frontier Markets ETF is a good proxy though it only focuses on the larger stocks for every market. It is heavy in financials at 45%, while telecom and consumer staples are each just above 10%. Real estate, energy, industrials and materials make up the following 20%.
Within the country ETFs the distribution may vary. In Argentina the IT sector is the largest (26%), while in Nigeria banks form as much as 54%. In Vietnam the largest sector are consumer staples at 19%.
Idiosyncratic risk makes for volatile investments that can diversify your portfolio
Frontier market stocks are typically illiquid and carry idiosyncratic risks. Meanwhile many emerging markets nowadays move in tandem, almost resembling one homogeneous asset class. This is one of the key attractions of investing in frontier markets, as for instance the risks and rewards of investing in Egypt have very little in common with what goes on in Argentina.
Within EM you could argue the same about Russia and Brazil, but statistically speaking their fortunes are more tied together. In the portfolio that I propose here, for instance Egypt and Nigeria have correlations of as low as 0.3 to 0.4 with the broader frontier market index. Vietnam on the other hand is a better representation of the average frontier market at 0.7.
Nevertheless, volatility on frontier markets is high and while on day to day basis they may move in different directions as the broader world stock markets, during a sell-off they would still be expected to be hit. The MSCI Frontier Markets index declined -54% in 2008, but only recouped +12% the following year. Emerging Markets saw a +78% return that year! In the next years the frontier set gradually made up for it, but it presses home the fact that this is a long-run investment.
Moreover, once you dig a little deeper you will also find plenty of similarities between frontier markets that may be less than appealing, often these will include things like corruption and ill-informed policies. The trick therefore is to find those markets that are improving on things.
Portfolio construction: four key markets and a broad market ETF
- I picked Egypt, Argentina, Nigeria and Vietnam for individual country ETFs as they are a good representation of frontier markets across Latin America, Asia, the Arabic world and Africa. Moreover, all of these are full replication ETFs meaning that they don’t make use of swaps or leverage (there is some securities lending involved, however)
- Given their higher TER, Nigeria and Egypt get a somewhat lower weight than Vietnam and Argentina. To minimise some of the bigger idiosyncratic risk, I coupled them with a broad frontier markets index.
- The volatility of the resulting portfolio is 9.9% with a yield of 1.0%. In a 2008 style crash scenario, the risk model predicts a decline of as much as -15%, but that may be somewhat understated.
|Egypt||Vaneck Vectors Egypt Index||EGPT||0.94%||10.0%|
|Argentina||Global X MSCI Argentina ETF||ARGT||0.59%||15.0%|
|Vietnam||Vaneck Vectors Vietnam ETF||VNM||0.65%||15.0%|
|Nigeria||Global X MSCI Nigeria ETF||NGE||1.10%||10.0%|
|Broad frontier markets||iShares MSCI Frontier Markets ETF||FM||0.79%||50.0%|
Risk, diversification and allocation
- Risk level: high
- Diversification: medium
- For risk and total return since initiation see Portfolios
- Probability of this theme playing out in the next 3-10 years: 50%-50%
Portfolio characteristics (full look-through, from USD perspective)
- Dividend yield: 1.0%
- Ex-ante predicted volatility: 9.9%
- 1 year 95% Value-at-Risk: -13.4%
- Scenario 2008 Lehman Brothers default period: -16.5%
- Scenario Interest rates +100bps: +0.9%
- Scenario 2008-2009: -14.8%
- Scenario 2010 onwards: +142%