Good Days for Frontier Stock Markets

Good Days for Frontier Stock Markets

Frontier markets are on course to enjoy a record year as investors scramble to put their cash to work in these risky and often illiquid markets. The MSCI Frontier Market index has gained 9% in the first six months of the year – its best performance for the year to date since the index was created five years ago. There are 25 countries in this index among them in Africa are Kenya, Nigeria and Mauritius.

Emerging Markets

Emerging markets are expected to power 60% of the world’s economic activity by 2030 and have become synonymous with growth. But the near-term outlook is murky, at best. Countries like Brazil, India and China that have arguably emerged now face a host of issues –from infrastructure bottlenecks to worries about credit expansion and income distribution. There are 21 countries in MSCI EM index including Egypt, Morocco and South Africa.

Two of the most popular so-called low volatility exchange-traded funds (ETFs) are the iShares MSCI Emerging Markets Minimum Volatility (EEMV) and PowerShares S&P Emerging Markets Low Volatility (EELV). The latter “seeks to create a low-volatility portfolio by employing a simple rule–it selects the 200 least-volatile stocks from the S&P Emerging BMI Plus LargeMidCap Index and weights each holding by the inverse of its volatility. The former uses a more complicated methodology , which looks not only at volatility but correlations as well and then makes sure you are not overweight in any one country or sector.

EEMV does a better job of tracking its index because it is slightly cheaper and has higher trading volume say analysts. EEMV has gained 6% during the past 12 months, while EELV has increased 4%. The one downside is both are not immune to large declines: EEMV’s index dropped 42% in 2008, while EELV’s fell 34%. Both beat the MSCI Emerging Markets Index’s 53% decline.

Frontier Markets

While a traditional emerging market (EM) benchmark is down year-to-date, frontier or “pre-emerging” markets have been performing well even as other emerging markets have fallen hard. Frontier markets are accessible through the iShares MSCI Frontier 100 ETF (FM), which has gained 7% this year when the iShares MSCI Emerging Markets ETF dropped 12% YTD.

Money flowing into frontier markets equity funds tracked by EPFR, a funds data provider, hit $2.27bn for the year to end of May, a fresh high for the period. Analysts at Citibank reckon assets under management in frontier markets (FM) have reached $17bn, up from $12bn in the middle of last year. This is merely half the market cap of Nigeria’s stock market of 2012.

Frontier markets are generally small and illiquid so investors should not make the mistake of thinking they can have a huge stake even when returns are higher than EM. And if the money flows reverse, the downside could be substantial. It does not take a lot of fund flows to propel a frontier market in either direction.

“So far in May, FMs have seen $250m inflows versus EM outflows of $1.3bn. Moreover, while global funds have been liquidating their EM positions to buy Japan or the US, this has not occurred in frontier, because few global investors own anything there. At the same time, the EM funds are raising their allocation to frontier equities,” says Citibank.

The divergence between EMs and FMs has been stark. While frontier markets – United Arab Emirates, Bulgaria, Kenya, Sri Lanka, Nigeria, Pakistan and Vietnam – made up the seven top-performing markets this year, the nine worst-performing markets – Peru, Czech Republic, Colombia, South Africa, Egypt, Russia, Poland, Chile and Morocco – are from the emerging world.

The risk-adjusted returns over a 10-year rolling period are smaller for frontier markets than for other investment areas. Even if one ignores measures of risk, such as beta and standard deviation, the returns themselves are less palatable than those of the emerging markets, developed international markets and the U.S.

Analysts seem to feel that the next 10 years will reward countries with the greatest potential for growth than that of traditional emergers like China and Brazil. Conversely, the near-term performance of a relative newcomer, iShares MSCI Frontier 100 Index Fund (FM), may have been the impetus.

On the other hand, it is hard to dismiss the reality that frontier market performance is all over the proverbial map. Guggenheim's long-standing Frontier Market ETF (FRN) has journeyed in the opposite direction, leaving its investors to ponder their frustrating allegiance to riskier regional assets.

Meanwhile, PowerShares Middle East North Africa Frontier (PMNA) has also been a disappointing under-performer.

At this moment, the best risk-adjusted rewards are likely to come from less volatile non-cyclicals in the emerging markets such as iShares MSCI Emerging Market Minimum Volatility (EEMV). There is less guesswork with respect to the breakout country ETF from the frontier or the emerging realm; moreover, there is less reliance on energy and materials to carry the day.

David Ryder MA MBA

Consultant. Commentator. Entrepreneur.

www.Viewonzambia.blogspot.com