Beware Frontier Market Pundits


A lot of the digital ink spilled out there about frontier markets usually focuses on incredible performance and double to triple digit gains. Writers have trumpeted gains in the MSCI FM, over 26% in 2013 and another 12% this year. These headlines will only get louder as developed markets trade sideways while frontier markets continue unperturbed.

We are firmly in the bullish frontier-market camp. We see strong value in investing in frontier markets. But we also have an interest in looking at the facts, and improving the dialogue around frontier markets, and most of those articles are pure fluff. This article in the normally excellent FT is a prime example of this sensationalism.

Here’s why:

1. The MSCI FM is a POOR proxy for global frontier markets

We touched on this in a previous post but it bears repeating: the MSCI Frontier Markets 100 Index does not resemble a global frontier market index. As of April 2014, almost 58% of the index was concentrated in three extremely wealthy Middle Eastern countries: Kuwait (20.37%), United Arab Emirates (18.99%), and Qatar (18.51%). Nigeria was the fourth largest country weight at 11.24%, which means that over 69% of the index is concentrated in four countries, three of which have GDPs per capita rivaling developed countries.

It is absolutely true that Middle Eastern stock markets, led by Dubai and Qatar, are on fire this year. But for a more rounded view of global frontier markets, check out our Market Dashboard. Frontier markets around the world are up an average of 5.6% or 2.5% in USD this year – still great, but not as much as the MSCI is saying, and with large variance across markets.

2. Currency returns MUST be considered

Investors gravitate to double digit YTD % returns numbers like moths to a flame. Unfortunately, those 38%+ returns in Argentina and Ukraine this year are in fact too good to be true. Why? Because their currencies have depreciated almost as much, with USD/ARS down almost 24% on the year and USD/UAH down a whopping 45%. That’s right, Ukraine is actually down on the year in USD terms despite a lot of conflict-driven bargain hunting.

Since currency risk is almost impossible to hedge in frontier markets (and still difficult for retail investors in emerging or developed markets), the performance of the local currency must be considered when calculating the overall returns of a stock market. Repeat after me: Don’t forget about currency.

3. Frontier Markets are inherently volatile

Low liquidity, greater proportion of retail/short-term vs institutional/long-term investors, and less developed financial markets will unsurprisingly lead to higher volatility in frontier markets. These are the caveats that every frontier investor must accept before investing. But articles such as the one linked to above in the FT seem to suggest that those factors actually contribute to lower volatility.

While it’s true that realized vols in markets around the world have generally moved lower, frontier markets still feature some of the most volatile markets in the world.

Both the S&P 500 and Euro Stoxx 50 Indices have had a realized vol of about 11% over the past year. In Ukraine, the realized vol has been about 28% over the past year, with the 30-day volatility hitting over 70% in March. Pakistan, the latest golden child of frontier markets, has a realized vol of about 15% over the past year despite incredible stability.

Throw in the relatively high volatilites in frontier market currencies, and utopian ideals of using frontier markets as safe havens go out the window.

Wait, so are frontier markets bad investments?

Not at all. Frontier markets  can indeed feature those double digit gains that pique most investors’ interest. Pakistan’s stock markets are up almost 14% this year and its currency has appreciated another 6%, resulting in over 21% in USD terms this year. Egypt is a great example of a turnaround story this year, with the market up over 28% YTD with its currency only down about 2.5%.

Diversification is also a great reason to allocate some money to frontier investments, and you can find the latest realized correlations we run here.

Frontier markets are a great way to take part in growing economies that are usually ignored by most investors. They are great markets for value investors willing to hold longer term, but not so much for day traders. But the most important lesson for any investor is to be aware of the risks before jumping into any new investment, and so we hope this post clears some of those issues up.

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