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Executive Insight – The foray into frontier markets and emerging economies

Emerging markets, less correlated to the ups and downs of the global economy, may be one way to diversify a portfolio

by Nadim Kabbara

For market participants and observers alike, 2011 brought about the sense that varying asset classes, which traditionally are not so closely linked to one another, had suddenly moved together in lockstep. This possibly shook some people’s belief in the benefits of diversification, attributed in modern times to Harry Markowitz under the Modern Portfolio Theory.

Riskier asset classes — from equities to high-yield fixed income and from real estate to currencies to commodities — have reacted in a similar fashion to the ebbs and flows of global headlines. Concerns of slowing economic growth from the two largest economies, the United States and China, uncertainty regarding the viability of the European Union and fears of a sovereign debt crisis in its southern members brought heightened nervousness and volatility to global markets.

Some market participants suggest that during times of market distress assets tend to move closer to, or to correlate with, one another. Looking at the severe stock market correction in 2009, correlation reached almost 0.9, according to MSCI index data (the maximum being 1 when securities move in perfect lockstep).

However, when markets are more volatile and risky — typically the time when investors cut back on perceived riskier assets and focus on safer holdings and domestic markets — the case for diversification across assets and markets should remain. One area where longer-term investors can capture higher risk-adjusted returns, while also benefiting from lower correlations to global markets, remains in emerging and frontier markets. The latter are economies with investable stock markets that have not reached the level of development found in emerging markets.

Within the context of weaker global economic growth, the International Monetary Fund has recently outlined the uneven two-stage recovery whereby emerging markets are leading economic growth, with 6 percent in real gross domestic product growth expected in 2012, compared to developed markets at 1.5 percent growth. Emerging markets boast growing populations, rising middle classes and current account surpluses, in contrast to developed markets that face aging populations and real sector issues in employment and housing, as well as required fiscal consolidation.

The MSCI Frontier Markets Index comprises the following countries from the Middle East and North Africa region: Bahrain, Jordan, Kuwait, Lebanon, Oman, Qatar, United Arab Emirates (UAE) and Tunisia. Qatar and the UAE are awaiting a decision by MSCI in December 2011 to be upgraded to emerging markets status, which would bode favorably for incumbents in these markets. Despite the higher risks in frontier economies, which consist of greater political uncertainty coupled with less developed economic, legal, financial and corporate governance frameworks, they have benefited from economic progress. While GDP per capita in frontier markets is low, at $4,200 on a purchasing parity basis in 2009, they achieved an average annual GDP growth of 4.4 percent between 2000 and 2009, slightly below emerging markets at 4.5 percent and double the rate of developed markets at 2.2 percent. In fact, 17 of the 20 fastest growing economies were from frontier markets over the same period, according to The Research Foundation of CFA Institute.

The relatively superior stock market performance of emerging markets is outlined using the latest MSCI index data. The MSCI Emerging Markets Index returned 6.8 percent on an annual basis over the past five years, as compared to 0.2 percent for the MSCI All Country World Index, and -5.2 percent for the MSCI Frontier Markets Index. While the MSCI Frontier Markets Index has relatively underperformed, the countries that comprise it represent more than 20 percent of the global population, 6 percent of global nominal GDP and 3 percent of global market capitalization, which suggests opportunities for investors as their economies and their stock markets reach the size and maturity of their more developed counterparts.

Longer-term investors should not overlook emerging and frontier markets as an area through which they can diversify their equity allocations and benefit from growing economies and markets less correlated to global developments. Despite the added volatility, equities have proven their place as an asset class that provides risk-adjusted growth to investor assets over longer periods of time.

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