If you are moving into an investment-related job, investing your own money, or just curious about global capital markets in general, this might be a rather interesting read for you.
As the US returns to growth, Europe starts recovering, and Abenomics actually start working in Japan, many investors will be keen on pulling back their capital invested into developed markets to capture some of that upside. However, an independent study I conducted with Professor Christopher Geczy last semester might suggest otherwise. The study aimed at analyzing the value of investing in small cap emerging and frontier (or pre-emerging) equity markets. We used MSCI’s public indices’ data as posted on their website. As there has been some public literature on the diversification value of emerging markets, there’s very little research that looks into frontier market indices, plus these indices were created by MSCI recently (public data available since January 2011).
While returns can easily speak for themselves, the diversification value of investing in small-cap markets can be more nuanced and this is what the study aimed to reveal. As we’ve learned in Corporate Finance, diversification is typically sought by portfolio managers as a means to smooth out non-systematic risks. The analysis herein assessed the correlations between standard-sized developed markets (large and mid-caps) and developed markets’, emerging markets’ and frontier markets’ small caps across different regions (regions were selected based on data availability and minimal noise, i.e. the EU and Middle East were excluded due to recessions and political instability, respectively). The hypothesis was that small-cap stocks in non-developed markets are the least exposed to developed markets’ macro-economies, thus providing the highest possible diversification in a global portfolio.
The hypothesis was indeed proven. Moreover, the results show far more interesting revelations when frontier markets’ correlations were taken into account. First, data from 2004-2013 show global emerging markets’ small caps’ correlation of 0.64 with that of the world’s large and mid-cap markets – with Latin America having the lowest correlation at 0.50 followed by Asia at 0.64. Assets that correlate less than 0.7 with other assets are considered highly suitable for diversification purposes in a portfolio, and the lower the correlation the higher the diversification value.
Returns (not risk-adjusted) between 2004 and 2012 have also been substantial with global small-cap emerging markets’ returns exceeding double of the world’s large and mid-cap markets, with Latin America tripling world large and mid-cap returns (as shown in the first column of the exhibit). Further, reviewing emerging markets’ data for 2011-2013 shows that the correlation has indeed decreased when compared to the 2004-2012 data set, with Latin America’s small-cap index reaching negative correlation with that of North America’s, signaling more decoupling of these markets with developed ones and the increasing attractiveness of them as a diversification tool.
Second, moving to frontier markets, while returns have had mixed results, the diversification value is outstanding. Some indices, such as Frontier Asia (which includes Bangladesh, Pakistan, Sri Lanka and Vietnam) are providing a negative correlation as low as -0.50 when compared to North American large and mid-cap markets. This suggests that frontier markets are nearly countercyclical to developed ones, allowing for even better opportunities for diversification in a global portfolio. Generally speaking, frontier (and emerging) markets have such low correlation due to their limited sensitivity to global market events due to low exposure to the developed markets’ base currencies (i.e. USD, EUR), their minimal trade (goods or capital) with developed markets and their low dependence on globally traded commodities (mainly oil).
There are additional reasons why frontier markets are attractive investments, as recently presented by investment advisory firm CrossBoundary in a webinar hosted by EMPEA.org (which we have access to as UPenn students). First, there is a perception arbitrage where valuations aren’t reflective of growth prospects and too much risk is priced in. JP Morgan estimated frontier markets’ as having the lowest price to equity ratios when compared to developed, US and emerging markets’ indices. Second, most investors have focused on the macroeconomic risks associated with frontier markets and not necessarily the returns or the real standard deviation of their public markets. Vanguard estimates frontier markets to have had the highest returns when compared to developed and emerging markets between 2000 and 2012, with a standard deviation that is far less than emerging markets and comparable to developed ones (σ FM= 17.2%, EM= 24%, DM= 18.4%). Third, there is extreme latent demand to be tapped into, as frontier markets represent 22% of global population, 6% of nominal GDP and only 3% of market capitalization, according to HSBC. Overall, frontier markets are quite underinvested and it is only a matter of time before investors realize their potential.
Despite the attractiveness outlined previously, there still remain significant inherent risks in frontier markets. According to Crossboundary and the IFC, the risks and issues include limited liquidity, low correlation of markets with GDP growth, susceptibility of the markets to macro and political risks and significant insider trading. Therefore, the best way to leverage these markets’ potential and diversification value is to pursue a stock-picking strategy (since there isn’t sufficient industry-specific indices) to focus on equities that are closely linked to consumer-driven markets (e.g. fast-moving consumer goods, real estate, services) and refrain from ones that are more exposed to government policy and/ or global markets (e.g. energy and natural resources, export-oriented businesses, financial services – except microfinance). In conclusion, frontier markets are an interesting addition to any global portfolio given the attractive returns and their diversification value. But a portfolio manager would need to put some additional effort into understanding the nature of such markets and mitigating or minimizing the risks to capture that latent value.
Legend: L+MC=Large and Middle Cap; SC=Small Cap; DM=Developed markets; EM=Emerging markets; FM=Frontier markets
N/A: Data not available as frontier market indices’ were constructed in 2011.
Please feel free to reach out to me to request the analysis or any of the sources used. Sherif.Yacoub.WG14@Wharton.upenn.edu