Are Frontier Markets More Volatile Than The US?
We have discussed Frontier Market Correlations and we track correlations on a regular basis. Our Frontier Market Dashboard looks at returns for all of the markets we watch. Volatility though, is something we haven’t explicitly discussed. What is volatility like in Frontier Markets? Is volatility in Frontier Markets fundamentally different from volatility in emerging markets or developed markets?
We wanted to answer these questions for you. Granted, many people have addressed Frontier Markets’ volatility, but it invariably ends up being a tertiary overview of volatility rather than a deep dive. Articles such as this one are consistent with the market consensus but it is always heavily reliant on the MSCI FM.
So to start off with, how volatile are Frontier Markets? We have used our investment universe (covered in the Market Dashboard) and provided 3-year volatility in 2014, 2011, 2009, and 2004. The data is as of May 31, 2014, but we will track it on a going-forward basis. For all the data and figures in this piece, we are using USD as the currency and returns have been adjusted as such.
Volatility, as has been cited by many before us is persistent and predictable. Lawrence Summers pointed it out in 1987, Pimm Van Vliet identified the low volatility phenomenon in stocks in the early 2000s and many in between those two have studied it. Volatility by and large can be predicted, returns cannot. The figure above bears that out. Relative to our Frontier Markets’ universe the United States clearly exhibits lower volatility than the average Frontier Market. The question then, is does this bear out on Sharpe Ratio basis (risk-adjusted returns)? See below and find out.
The answer isn’t very clear. In the last three years, the United States significantly outperformed Frontier Markets on a risk-adjusted basis. The US though has left most other markets behind rising almost 40% in 2013. This cannot continue. Looking at other time periods, 2011, 2009, and 2004 it is clear that the United States is in fact below the median Frontier Market on a risk-adjusted basis.
We can confidently say that over time, Frontier Markets provide better risk-adjusted returns that the US market. This is one of the main reasons why we think a Frontier Markets’ portfolio has a place in a well-diversified portfolio.
You are probably wondering how particular domestic equity markets have performed. Well, you can find that information at the end of this piece. Blanks indicate that information is unavailable for a particular country.
Before we get to that, see the tables below that outline the top 5 and bottom 5 for some of the periods we looked at.
The one caveat when looking at volatility in emerging markets is the issue of liquidity. We have addressed this in this post. Certain markets that are not liquid will have limited price movement and exhibit lower volatility. A good example of that would be Trinidad and Tobago where it exhibits low volatility and a high Sharpe Ratio. This is primarily driven by poor daily liquidity. The is an issue that those that invest in alternative assets are well-versed in. Real Estate and Infrastructure are valued quarterly if not annually. The infrequency of valuation results in low volatility characteristics which implies a lower volatility profile than the asset class actually has.
With that caveat in mind, we think that looking at Frontier Markets on a Sharpe Ratio basis is quite useful in informing investment decisions.
Any questions, please do let us know. We have done this analysis on a 5-yr basis as well and the information results in similar questions.