Investors are becoming increasingly familiar with emerging markets (EMs), but frontier markets remain something of an unknown.
Frontier markets are early-stage EMs. Generally speaking, the latter are characterised by lower per capita income and less developed capital markets than developed markets.
In turn, frontiers have lower income levels and still less developed markets than their emerging cousins. The breadth and maturity of their capital markets, as well as political developments, are also factors sometimes considered.
This somewhat vague definition has occasionally resulted in anomalies. For example, Qatar, the world’s richest country per capita, was only recently upgraded to emerging from frontier status, while Saudi Arabia, whose per capita income exceeds almost every European nation, is not yet even a frontier market.
However, emerging and frontier market indices have been a useful starting point in looking at what is a very broad investment universe. For stockpickers, the ongoing expansion of the investable universe provides inefficiencies from which they can seek profit.
There are a number of catalysts that lead to the upgrading of a market to EM status, including trade and capital markets liberalisation, increased foreign participation and political change.
This transition can be highly lucrative for stockmarket investors, but is also punctuated by macroeconomic dislocations, policy turnarounds and mixed corporate governance.
The 1980s saw the end of military dominance in some leading Latin American nations. As the decade ended, the fall in communism in Central and Eastern Europe led to the (re)creation of capitalist systems and markets in these countries which then acquired EM status.
One difference between the average emerging and frontier market is their level of foreign ownership. The amount of assets dedicated to EMs, both actively and passively managed, is substantially higher than that for frontiers.
Despite the great strides of globalisation in the past 40 years, investment strategies are often highly localised. The MSCI World index has around 11 per cent in EMs, yet the average fund measured against that index only holds 8 per cent in EM and frontier market firms.
Moreover, to the extent that they are diversified, portfolios are generally benchmarked against indices that reflect the past rather than consider likely future outcomes – in this case, the strong historic outperformance of developed markets verses EMs and frontiers.
The landscape continues to evolve. Emerging and frontier countries account for about half of the global economy, adjusting for purchasing power parity, and 85 per cent of the world’s population. Developed economies are growing at scarcely 2 per cent a year, while the ‘other 85 per cent’ is growing at well over twice that rate.
Malaysia, the largest EM in 1990, when it accounted for 25 per cent of the MSCI EM index, is now ranked 10th with a 2.5 per cent weight. Of the world’s 20 most populous countries, only three – the US, Japan and Germany – are considered developed. Of the remaining 17, just 10 are emerging. In other words, seven – Pakistan, Nigeria, Bangladesh, Ethiopia, Vietnam, Congo and Iran – are barely on anyone’s radar.
