Via Index Universe, a report on the next emerging markets:

As emerging markets have grown in popularity and significance over the last two decades, many of the benefits of investing in these once-idiosyncratic markets have diminished, to some extent. The correlation of emerging markets with developed markets has steadily risen, eroding diversification benefits. If anything, the fact that emerging markets represent 12.6 percent¹ of the world’s total market capitalization reflects the reality that emerging markets are widely recognized as a major asset class and should be a key component of any global equity allocation, whether large or small. The question now is, Are these markets truly emerging?

For investors looking to capitalize on the expected future growth of a premature asset class—perhaps the essence of what an emerging market should be—the answer is likely no. And that raises the question of where investors should look next. A logical next step is to explore underdeveloped asset classes like frontier markets, which offer high growth potential and immense diversification benefits. This article does not seek to discourage investment in emerging markets; rather, its goal is to explore the benefits and challenges of investing in frontier markets, as well as to evaluate which characteristics make this a truly alternative equity asset class.

In the last three years, globalization has caused an insatiable hunger for alternative and uncorrelated asset classes. Investors have become more curious about what frontier markets have to offer, and a handful of institutional investors have invested in them in hopes of capitalizing on this asset class over the long term. As a result, frontier markets, benchmarks and investment vehicles have begun to evolve rapidly, making the asset class more accessible to foreign investors. Since frontier markets still remain an undeveloped asset class, caution must be exercised and investments must be further evaluated from practitioners’ points of view. This article will also explore the benefits and fundamental obstacles to investing in frontier markets in hopes of providing investors with the essential information needed to make an informed investment decision.

What Is A Frontier Market?
For the purposes of this article, any country that falls outside of the MSCI All Country World Index can informally be referred to as a frontier market. At the most basic level, frontier countries can be broken down into two general categories: countries that are economically advanced, and those that are not. This unlikely combination makes frontier markets an unconventional yet intriguing asset class, where each market is in a different stage of economic advancement. A handful of frontier markets are actually more economically advanced than some emerging markets. Several countries in Eastern Europe and in the Middle East² fall within this category. Despite the level of wealth and economic prosperity, constraints around foreign ownership limits, operations and liquidity preclude economically advanced frontier markets from being classified as emerging or developed economies. In contrast, other frontier markets—including Botswana and Bangladesh—are truly pre-emerging, underdeveloped economies. These markets tend to have precarious political backdrops, where corruption is endemic, and often simply lack the structure to support extensive institutional investments. Other markets in their infancy—such as Cambodia—are in the process of launching a local exchange, but have yet to attract and convince local companies to actually list on the new exchange. In aggregate, some 30 to 40 countries in both categories are considered investable frontier markets.

The Lure Of Frontier Markets
An allocation to frontier markets provides a more complete geographic exposure to global equities. By excluding this market set, investors are omitting a number of major markets and even entire regions, in some cases. The most noticeable gap is in the Middle East and Africa, both of which are almost completely excluded from the MSCI ACWI Index. Israel, South Africa, Egypt and Morocco are the sole African and Middle Eastern markets included in that index. Eastern Europe is also home to a number of frontier markets, as is Southeast Asia. Most major markets in South America are currently classified as emerging markets—Argentina is the only major frontier market in South America.

By omitting frontier markets, investors are also sacrificing a number of valuable benefits. Several telltale signs that will be explored further throughout this article suggest that frontier markets are on the verge of economic advancement. In addition, the unique makeup of frontier-market companies creates a distinctive and unusual asset class that renders immense diversification benefits. Accordingly, correlation levels among other asset classes also remain low, making frontier markets a valuable complement to an equity allocation. Despite their advantages, frontier markets surprisingly remain virtually untouched by outside investors, indicating that a first-mover’s advantage may still exist.

Uncovering Tomorrow’s Growth
The historical growth of underdeveloped market segments sets a compelling backdrop for the potential economic advancement of frontier markets. The growth progression of emerging markets over the last 23 years can be seen in Figure 1. Remarkably, the market-capitalization rate of emerging markets in the early 1990s was about US$100 billion,³ approximately the same size of frontier markets today—a reminder of the rapid growth potential of untapped markets.⁴ While not every frontier is destined to be the next China or India, it is conceivable that a handful of these markets will mature and converge with more-developed countries. Early investors in frontier markets may enjoy the growth in capital that accompanies such a convergence.

While market capitalization provides a useful means of depicting the size of a country’s capital market structure, it does not always fully depict that country’s actual economic output. This is especially true in emerging or frontier economies, where the current capital markets are generally less developed and underutilized. This is well illustrated in Figure 2, which compares a country’s or country classification’s output in terms of GDP against its current percentage of the world’s market capitalization. A clear discrepancy can be noted between the two: Frontier markets represent only 0.3 percent⁵ of the world equity market capitalization but account for 6 percent⁶ of the world output in GDP. Similarly, the contribution of GDP output for emerging markets is 21 percent, yet only accounts for 13 percent of the world’s equity markets. As capital markets in emerging and frontier markets become more robust and as investor momentum increases, this divergence may narrow over time, causing market capitalization values to converge toward levels that are more in line with their proportion of the world’s GDP.

Which factors will fuel future GDP growth? For frontier markets, population growth, low debt relative to GDP, and an abundance of natural resources all set the stage for vigorous economic growth.

Population growth is a crucial factor in large-scale economic advancement. Currently, about 30  percent of the world’s 7 billion people reside in frontier markets. Within the next 40 years, the world’s population is expected to rise by over 2.3 billion, bringing the total population to nearly 10 billion.⁷ Africa alone, which is home to a large majority of markets in the broader frontier universe, will account for nearly half the population growth during this period. As population rises, so does consumption, thus stimulating spending and demand for labor. For example, several major global firms like Unilever, Guinness and Nestlé now operate local lines in Africa, in recognition of strong consumer demand in these expanding economies.

The age distribution within the frontier markets population also sets the stage for future growth. Over half of the world’s people are currently under the age of 25, suggesting there will be a profusion of young adult laborers to draw from in the future and fewer older workers at or near retirement (Figure 3). Most developed economies like the United States and Japan are faced with hefty expenditures such as social security and Medicare that support an aging population. The absence of this older populace in frontier or emerging economies is a major reason the debt-to-GDP ratio is, on average, substantially lower than that of developed markets. Lower debt enables governments to allocate more funds toward social and infrastructure spending, further supporting future economic growth.

The consumption needs of a growing population also stimulate the demand for natural resources. The fact that frontier markets contain an abundance of the world’s vital natural resource reserves makes them a key beneficiary of future expansion. For example, consider global oil reserves. The broader frontier-markets universe contains over 78 percent of the world’s oil reserves, while developed and emerging markets hold around 14  percent  and 8  percent, respectively.⁸ Frontier markets also hold more than 60 percent of the world’s natural gas reserves⁹ and are the principal bearers of such major metals as aluminum, zinc and cobalt.

Exploring Diversification And Correlations
Correlations among major equity markets have risen steadily over the last decade, diminishing the benefits of diversification. However, frontier markets have a remarkably low correlation among other asset classes, leading to meaningful diversification benefits. For example, over the last five-year period, the correlation between the MSCI Emerging Markets Index and the MSCI EAFE Index was 0.9.¹⁰ Yet as seen in Figure 4, correlations among frontier markets remained low during that same period. Investors often utilize nonequity-based assets like commodities to increase diversification, and frontier markets might play a similar role: Another unexpected feature of frontier markets is the low correlation to commodities. Despite the abundance of natural resources and the perceived high exposure to commodities, the MSCI Frontier Markets Index and the S&P GSCI both have a correlation of only 0.26.

Frontier markets also have low correlations with each other. Companies in frontier markets tend to focus on local sources of demand, thus creating a somewhat insulated economy whose business activity is largely unrelated to that of companies in other frontier markets. For example, Krka d. d., Novo mesto is a Slovenian pharmaceutical company that owns 23 subsidiaries focusing on health and tourism in the surrounding Eastern European and Balkan countries. And Nigerian Breweries is Nigeria’s largest brewing company. It is difficult to find a commonality between a Slovenian-based pharmaceutical company focusing on the production of generic drugs, and beer consumption in sub-Saharan Africa. Low intramarket correlation also manifests as a result of differences in sectors at the regional level. For example, Africa has a large exposure to consumer staples, while the Middle East is concentrated in financials and telecommunication. These types of contrasting relationships at the sector and constituent level help explain why the average intramarket correlation of the frontier markets basket is only 0.4¹¹ over the five-year period between 2007 to 2012. Figure 5 further illustrates the low to moderate intramarket correlation within the frontier markets basket. In contrast, assets within developed markets (including the United States) and emerging markets tend to show high interdependence, due to the impact of macro events and globalization. The intramarket correlation during the same period was 0.8 and 0.7 for developed and emerging markets, respectively.

Examining intramarket correlations also sheds light on risk and the overall volatility of an asset class. Consistent with what we would expect, the average volatility of each individual frontier-market country is higher than the comparable average volatility of individual developed and emerging markets. However, the low average intramarket correlation of frontier markets leads to a counterintuitive result when looking at the volatility of a cap-weighted basket of frontier securities. The five-year volatility of the MSCI Frontier Markets Index is only 24 percent, which is on par with the volatility of the developed MSCI World Index (also 24 percent).11 The MSCI Emerging Market Index had the highest overall volatility (30 percent) of all three asset class, challenging the idea that frontier markets are riskier than other equity markets.

A Map Of The Frontier
Although institutional investment in frontier markets remains in its infancy, these capital markets and the benchmarks and vehicles that track them have started to evolve rapidly, making the asset class more accessible to foreign investors. Because frontier markets remain an underdeveloped asset class, investors should use due caution in evaluating potential frontier investments.

A number of major index providers, such as MSCI, Standard & Poor’s, FTSE and Russell Indexes, further break down the frontier universe by applying a set of criteria that broadly cover investability and accessibility, as well as liquidity and other general guidelines for economic stability. The criteria for inclusion are less stringent than for developed and even emerging markets. Standard frontier markets indexes based on market capitalization are relatively similar and typically contain approximately 25 countries. Depending on the index provider, some countries may be classified differently,¹² or the universe may include or entirely exclude certain markets. Despite the “investability” reviews of benchmark providers, not all countries in the frontier markets indexes are actually investable. Trinidad and Tobago is one example of a country that was deemed suitable for inclusion into the MSCI Frontier Market Index in 2009 but was removed three years later due to insufficient liquidity.

For simplicity, we focus our remarks here on the MSCI index series, which began coverage of frontier markets in 2002. Figure 6 includes a list of countries and their corresponding weights in various MSCI frontier markets indexes. Frontier managers will utilize each index for various reasons. For instance, the MSCI Frontier 100 Index targets the largest and most liquid 100 names in the MSCI Frontier Market universe, making it an ideal index for investors that require a more liquid benchmark. The MSCI Frontier Market Index is a broad-based index that simply weights countries according to their market capitalization. The disparity in country market capitalizations can cause a cap-weighted index to be heavily weighted in specific markets. For example, Kuwait accounts for roughly 27 percent of the MSCI Frontier Markets Index. To arrive at a more diversified frontier markets index, many index providers have released frontier benchmarks that cap individual country weights. Capped indexes not only limit the exposure to certain markets, but they increase diversification, which is crucial to mitigating risk.

Regardless of weighting methodology, any broad frontier strategy will still tend to have a large exposure to the Middle East. The total market cap of all Middle Eastern countries combined is roughly 59 percent of the MSCI Frontier Markets Index. Figure 6 also shows a complete regional breakdown of various MSCI indexes.

An often-cited criticism of frontier markets is that the high exposure to the Middle East diminishes diversification and introduces a perceived concentration in energy. As noted earlier, the Middle East is predominantly made up of financials, telecommunication and real estate securities. In total, the MSCI Frontier Market Index has only an 8.8 percent¹³ weight in the energy sector, as shown in Figure 7. For comparison purposes, the S&P 500 has a sector weight of 11.3 percent¹⁴ in energy. This surprisingly low weight in the energy sector in frontier markets is attributable to the fact that the energy industry in the Middle East is owned and operated by the governments. Even though energy still remains the most significant source of commerce in the region, the returns of other markets like the United States also show a similar level of correlation with the price of crude oil. The investable Gulf Cooperation Council (GCC) countries,¹⁵ for example, have a correlation of 0.7¹⁶ with crude.¹⁷ The correlation between the S&P 500 Index and crude is 0.6. While the investable GCC countries have a higher correlation, this example shows that other major world economies are not immune to the influences of the energy sector either.

Risks And Obstacles To Consider
It is worth noting that precious few dedicated frontier markets strategies are available to investors. Many strategies labeled as such in fact have exposure to several emerging markets countries. Lack of liquidity in certain frontier regions, like Africa, may prompt managers to include an emerging market country in the same region, like South Africa. Other common inclusions are smaller-cap emerging market countries like Colombia or Peru. In a risk-on environment, funds that include emerging markets will tend to outperform those that strictly focus on frontier markets. The drawback with this approach is that investors may be inadvertently adding undue risk to their overall portfolio as a result of the overlap in specific countries held in other emerging market strategies.

While the benefits described earlier are compelling, investors should also be aware of challenges of investing in frontier markets. First, similar to emerging markets of 20 years ago, frontier markets are generally less liquid than developed or emerging markets. For example, as of the end of September 2012, the 30-day average trading volume for the frontier markets basket was approximately $169 million.¹⁸ Second, frontier markets are expensive to trade in. Transaction costs can be in excess of 100 basis points¹⁹ for a diversified portfolio of frontier names. The universe of constituents held in most major frontier indexes is also limited to around 150 to 200 securities. In addition, volatility of individual securities and countries can be quite high, suggesting that a well-diversified approach is prudent. As noted earlier, risk can be minimized by holding a well-diversified portfolio to best capture the benefit of the low intramarket correlation of frontier markets.

Further, actually obtaining exposure to the small subset of investable frontier market constituents is no small feat. When possible, obtaining local exposure in international markets is ideal, as it minimizes tracking error, assuming that the benchmark of a strategy utilizes local market equity lines. In more obscure markets, such as emerging or frontier markets, establishing local access poses challenges for even large institutional investors. The time required to set up accounts can be quite protracted and cumbersome. The benefit of accessing local securities must be weighted in light of the upfront setup costs. Many managers have instead used ADRs, GDRs and derivatives such as P-notes and swaps. Wide spreads and additional counterparty risk make derivatives a less attractive means of obtaining exposure. However, derivatives like a P-note may be the only means of obtaining exposure in a country such as Saudi Arabia that is closed to foreign investors.

When investing locally, operational inefficiencies remain in even some of the more economically advanced frontier markets. For example, MSCI has for several years considered promoting U.A.E. and Qatar from frontier to emerging markets status. However, its stringent foreign ownership restrictions, along with the onerous requirement for dual account structures, have resulted in both markets remaining in MSCI’s frontier category. Nonetheless, each of these countries has successfully attracted foreign investment over the last decade.

As markets have opened to foreign investors in recent years, the number of investment vehicles has also multiplied. A large majority of frontier markets managers focus on active management, though passive investing is also being explored as a less expensive alternative. Institutional long-only active management fees can range from 125 to 228 basis points,²⁰ while passive management fees are typically 100 basis points or less. Active funds also tend to have higher turnover and transaction costs, which can quickly erode alpha. Illiquidity and the lack of quality fundamental data in frontier markets make them a difficult environment to support active signals or to make active bets of a meaningful size. Additionally, in some countries, corporate actions and rights offerings may be published solely in those countries’ local languages, creating further challenges for active managers. Another consideration is that few frontier markets allow shorting, thus further limiting opportunities for active management.

For these reasons, some investors have turned to passive investing. A number of passive and active exchange-traded funds have been launched in the last several years. The fact that ETFs have daily liquidity and can be shorted makes them attractive investment vehicles. Liquidity can, however, be a double-edged sword. The lack of liquidity in many of the underlying stocks within the broader frontier markets universe can prohibit daily liquidity.

As a result, many frontier market ETFs focus on either the most liquid securities within the frontier universe or the most liquid countries or subregions, like the Middle East Northern Africa. The desire for more broadly based frontier ETFs was what prompted the 2012 launch of the MSCI Frontier 100 Index. While the smaller investment universe reduces the benchmark’s diversification to the largest and most liquid names, it is still arguably the most complete and most liquid frontier index available, making it well suited for ETFs. Similarly, FTSE offers the FTSE Frontier Index, which focuses on the 50 most liquid names in the frontier markets universe.

As interest in frontier markets grows and more strategies are launched, investors will likely choose to transact locally in order to be more efficient over the long run. In certain markets, foreign institutional investors pay exchange fees to transact on local exchanges. Exchanges then employ these funds to modernize and enhance exchange technology. As technology and transparency within markets improve, broad cost compression typically follows suit. As a result, markets become ever-more efficient. In the end, the ultimate beneficiary throughout this sequence of events is the investor.

The Future Of Frontier
The growth potential and diversification benefits of frontier markets make them an attractive long-term investment. The characteristics of such markets provide investors with access to the consumers and the resources of tomorrow, without the crippling debt overhang that may stifle the growth of more-indebted developed nations. The local demand engine of frontier markets also drives the low intramarket correlations that deliver the diversification so sought after by investors.

Frontier markets have evolved significantly over the last few years and continue to attract the attention of institutional investors. Improving operational infrastructure and liquidity would further support additional investment by institutions. Early investors will enjoy the expansion in market capitalization that accompanies the continued development and success of frontier markets. As illustrated in Figure 8, valuations in frontier markets remain significantly lower than those of emerging or developed markets, suggesting that investors have a welcome opportunity to take advantage of an attractive entry point to the next generation of emerging markets.