Stay Connected!
ETF.com News Daily
ETF.com News Weekly
Sign up to ETF.com's newsletters.
U.S. Edition
Search Ticker
Journal of Indexes

The Next Emerging Markets

Share:

The Origins And Evolution Of Delta-One

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.

Figure 1


 

Discussion

Post a Comment
Comment:
Name:
E-mail:
Home page: (optional)
CAPTCHA Image Reload Different Image
Type in the
displayed
characters:
Email follow-up comments to my e-mail address SUBMIT

IndexUniverse is excited
to announce our new name: