Frontier markets have been gaining attention from market watchers and investors alike in recent months.
The MSCI Frontier Markets Index has outperformed its developed and emerging market counterparts so far this year, as investors have been searching for growth and bargains in a slow-growing world where most major asset classes appear fully valued.
However, despite frontier markets’ increasing popularity, many investors are approaching frontier stocks too narrowly, viewing them as a subset of their emerging markets’ allocation and selling off part of their emerging market equities’ exposure to gain access to the frontier.
As my colleague Kurt Reiman and I write in our new Market Perspectives paper, “Investing on the Frontier,” frontier markets should not be lumped in with emerging markets and instead, they should be viewed as a separate asset class, a view I’ve been advocating for a while. As we write in our new paper, there are three reasons why investors should now consider having a portfolio allocation, albeit a small one, to frontier markets over the long term, while maintaining their exposures to developed and emerging markets.
The potential diversification benefit. Two to three decades ago, when emerging markets were at an earlier stage of development, their stocks weren’t that correlated with those developed markets. However, over the last 25 years or so, emerging markets have become more global. As a result, stocks in emerging markets like China and Brazil now actually have a high correlation with U.S. and European equities, meaning they all tend to move in the same direction.
Most of the countries that dominate frontier markets, on the other hand, are very locally oriented. They’re local banks and agriculture companies that are very tied to the local economy. This means that frontier market stocks have a lower correlation with other equity markets than emerging market equities. In short, with frontier markets, you’re potentially getting back a little bit of that lost diversification benefit that you used to get from investing in emerging markets.
Lower volatility. Equities, in general, come with a lot of volatility and frontier markets are no exception. Still, on a relative basis the volatility of frontier markets has historically been lower than you might expect. Because frontier market stocks are less correlated with each other compared with the correlation between equities of various emerging markets, frontier market stocks’ volatility has historically been below that of emerging markets. As such, frontier markets have, at least historically, helped provide upside potential for even conservative-leaning portfolios.
Faster growth. Frontier market economies seem poised to grow faster than both developed market and emerging market economies over the next few decades. This is partly thanks to frontier countries’ generally better demographics. Unlike emerging markets, based on United Nations data, frontier markets universally have young, growing populations, which, over the long term, are mostly good for economic growth.
In addition, frontier market countries are in a very early stage of growing per capita income. The advantage of being in an early stage is that it’s easy to catch up— frontier countries can basically adopt technology from more established markets and use it to accelerate their growth rates.
However, while there is a strong case for embracing the frontier, it’s important to recognize that markets in the so-called “pre-emerging” world are not without significant risks. Not only do you have the same risks you’d have with any developed and emerging market, but there also are a number of risks specific to the frontier.
There is a higher risk of political turmoil in frontier market countries, of course. Plus given that frontier markets are at relatively early stages of development, particularly with respect to their financial markets, they offer limited liquidity. The high concentration of financial stocks in frontier markets also means that these markets could be hurt if there is a global banking sector downturn. Finally, frontier markets also could suffer if investors regain enthusiasm for emerging markets.
To be sure, given frontier markets’ strong showing in recent years, many investors are wondering whether they should still consider investing in the frontier, especially considering the risks mentioned above.
My take: It’s certainly true that frontier markets have had a big run this year and they’re not without their risks, but their diversification benefits, lower volatility and growth potential warrant their inclusion as a long-term strategic holding in most portfolios, with one caveat. Given that the asset class is now closer to being fully valued, investors may want to use techniques like dollar cost averaging to slowly gain exposure to frontier stocks.
Sources: BlackRock, Bloomberg
Russ Koesterich, CFA, is the Chief Investment Strategist for BlackRock and iShares Chief Global Investment Strategist. He is a regular contributor to The Blog and you can find more of his posts here.