In addition, the overall correlation between frontier markets and developed markets is lower than the correlation of emerging markets with developed markets. Since January 2008, the correlation between the MSCI Emerging Markets Index and the MSCI Developed Markets Index was 92% compared with 78% for the Frontier Markets Index. In other words, an allocation to frontier markets would have offered some diversification to the total equity portfolio due to its lower overall risk and its lower correlation properties.
Consider that since 2008 a 10%/90% mix of Emerging Markets and Developed Markets would have delivered risk of 22% whereas a 10%/90% mix of Frontier Markets and Developed Markets would have delivered risk of 21% — a full one percentage point less.
It’s important to remember that frontier market event risk, both on the policy and political fronts, is higher than the average emerging or developed market. But a small allocation to frontier markets can provide investors with access to the early development in these economies while potentially offering the benefit of diversification.
[1] Data is from Bloomberg. Daily index levels are collected for each index and monthly returns are computed from September 1992 to September 2012.
[2] Note that 2008 is the first full year for which the MSCI Frontier Index has a “live” track record.
Daniel Morillo, PhD, is the iShares Head of Investment Research.