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Are Frontier Markets about to get even riskier?

Investors in emerging markets funds have endured a turbulent ride in recent times, with the MSCI Emerging Markets Index significantly underperforming the developed market MSCI World Index for three years on the trot and undershooting it by more than 32% over three years. The last twelve months have been particularly painful, with losses weathered on a total return basis as concerns have mounted over a combination of factors including the deceleration of growth and size of credit expansion in China, the exposure of structural imbalances in a number of emerging market economies and the wind down of the US Federal Reserve’s quantitative easing stimulus programme, of which the emerging world has been a collateral beneficiary.

Jason Hollands Jason Hollands
07 May 2014

Yet over this same period, the so-called “Frontier Markets”, representing the tier of countries below emerging markets in terms of development, have raced ahead, with the MSCI Frontier Markets Index outperforming the MSCI Emerging Markets Index by 43% over the last three years. And while the MSCI Emerging Markets Index has seen annualised volatility of 15.5% over the last three years, the Frontier Markets Index has experienced much lower volatility of 11.4% which is only marginally ahead of the MSCI World Index at 11% and surprisingly less than our own FTSE All Share Index which has experienced volatility of 12.2% pa.

It may surprise investors to hear that funds invested in the 26 countries in the MSCI Frontier Index, which include the likes of Vietnam, Kazakhstan, Nigeria, Kuwait and Ukraine, have actually been less volatile than the UK-stock market in recent years, let alone the emerging markets, but as always backward-looking data needs to be handled with extreme care!

The relatively low correlation between the Frontier Markets and other indices is in large part a function of fact that they are less open and therefore have not been buffeted by the ebbs and flows of international capital that have pummelled emerging markets over the last twelve months, hitting currencies, equities and bonds.

But there is another reason why investors who are tempted to chase the recent performance of the Frontier Markets need to be wary of past data and that is the major changes to the index that came into effect this month with the elevation of Qatar and the United Arab Emirates from Frontier Markets to Emerging Market status. While this change in index composition will have a relatively minor effect on emerging market funds, with both the two Middle Eastern economies collectively representing around 0.7% of the MSCI Emerging Markets Index, the impact on the equivalent MSCI Frontier Markets Index will be dramatic. The UAE has represented approximately 18% of the MSCI Frontier Markets Index, while Qatar has accounted for approximately 16%.

In many ways there are two types of “Frontier Market” economy: those which are at an early stage of economic development, such as Kenya or Bangladesh, and those where GDP per capita is actually quite high but where capital markets have been historically relatively restricted, such as Saudi Arabia. With the elevation of Qatar and the UAE, the Frontier Markets universe says farewell not just to a third of the index by market-cap but also two constituents with very high current account balances as a percentage of GDP and which have been making good progress towards diversifying away from oil revenues into service sectors.

With the re-setting of the Frontier Markets universe much more towards economies at an early phase of development, the risk profile of these markets changes too.

Does this mean investors should now avoid Frontier Markets? Absolutely not. But it is important not to be swayed by recent returns and believe these are on course to be repeated in the near term. Anyone contemplating exposure to either Frontier Markets or Emerging Markets in their portfolio should be prepared to take a very long-term perspective in our view and only allocate a modest percentage of their portfolio to these high-growth, higher-risk economies.

Our favoured frontier markets investments are the Bestinvest four-star rated Blackrock Frontiers Investment Trust (trading at a small premium of 0.9% of NAV compared to 3% 52 week average) and the three-star Templeton Frontier Markets fund.

For global emerging markets exposure our top rated vehicles are the Lazard Emerging Markets fund and Templeton Emerging Markets Investment Trust (trading at an 11.2% discount to NAV compared to a 10% average), both of which are rated four-stars by our research team.

Different funds carry varying levels of risk depending on the geographical region and industry sector in which they invest. You should make yourself aware of these specific risks prior to investing.

Underlying investments in emerging markets are generally less well regulated than the UK. There is an increased chance of political and economic instability with less reliable custody, dealing and settlement arrangements. The market(s) can be less liquid. If a fund investing in markets is affected by currency exchange rates, the investment’s value could either increase or decrease in response to changes in those exchange rates. These investments therefore carry more risk.