This article was originally published in October 2013.
ETFs make it easier for advisors to investigate frontier markets for untapped market exposures. However, our research suggests such markets may convey more risks
Some market watchers believe future economic growth looks strong. They assume frontier markets can aid investors in building a more diversified portfolio, and capturing growth similar to emerging markets.
But take a close look at these assumptions and these arguments becomes less compelling.
Expectations for robust economic growth
The International Monetary Fund expects frontier markets to enjoy economic growth similar to that of emerging markets through 2017 (4.47% versus 4.67%, respectively). By comparison, the IMF projects many developed nations will face anemic growth. Such discrepancies are a primary reason for interest in frontier markets.
But studies indicate the correlation of economic growth and stock returns over typical investment horizons are near zero.
The relationship between these two across countries is strongly influenced by a number of factors, including:
- Growth surprises — how a country’s actual GDP growth compares with earlier expectations for growth priced by financial markets;
- Valuations — the price investors pay for a market’s expected growth at any given time; and
- Globalization — how a country’s GDP growth relates to the earnings growth of the country’s domestic public companies.
Potential for diversification
Since January 2000, frontier markets have posted attractive correlations. However, averages don’t tell the whole story.
From 2000 to 2007, correlations between frontier markets and various asset and sub-asset classes were generally low. However, since 2008, correlations to other risky assets have increased — substantially in some cases.
The next emerging markets?
Investors may turn to frontier markets if they missed out on the rapid growth of emerging markets. However, the frontier/emerging markets analogy doesn’t hold up.
As a percentage of global market capitalization, frontier markets have lagged behind emerging markets at every point in history.
In 1990, emerging markets accounted for 2% of the global market cap, according to Vanguard. In September 2012, frontier markets accounted for only 0.36% of the global market. And from 1990 to 2000, emerging markets had grown to almost 6% of the global market. Frontier markets haven’t surpassed 0.54% of the overall market at any point in history.
For frontier markets to continue to increase their collective footprint in the global marketplace, an index would need to:
- Increase the size of its existing markets through the addition of new publicly traded companies;
- See its current constituents grow at a rate exceeding those of developed or emerging markets in aggregate; or
- Add new countries or markets.
The value of global allocations
Non-Canadian equities account for over 90% of global market capitalization, representing a significant diversification opportunity for investors. For example, the portfolio of an investor who combined non-Canadian equities with Canadian equities over the past several decades would have experienced lower average volatility — despite similar realized returns and volatilities in each region.
But frontier markets represent a tiny slice of the global equity market. Questions remain about whether focusing a portion of one’s portfolio on these markets can benefit a portfolio. In addition, concerns persist about whether these markets’ reduced liquidity and ongoing political risks will continue to overshadow any potential benefits.
Notes: Returns cover January 31, 2000 through September 30, 2012. Benchmarks include: Frontier markets—S&P Frontier BMI ex GCC Index from January 31, 2000 through November 30, 2007, and MSCI Frontier Markets Index thereafter; foreign developed-markets equity—MSCI World ex USA Index; foreign emerging-markets equity—MSCI Emerging Markets Index; foreign developed-markets fixed income—Barclays Global Aggregate ex U.S. Bond Index; foreign emerging-markets fixed income—JPMorgan Emerging Markets Bond Index; U.S. REITs—FTSE/NAREIT Equity REIT Index; commodities—Dow Jones UBS Commodity Total Return Index. Data cover the period from January 31, 2000 through September 30, 2012.
Sources: Vanguard, using data from Thomson Reuters Datastream