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The case for frontier markets in a diversified portfolio
Index provider FTSE has produced a paper on the potential and risks provided by the 26 frontier countries and 368 stocks that make up the FTSE Frontier Index. Lower volatility than both emerging and developed markets is a surprising plus for the frontier index.
The paper, ‘Frontier Markets: Accessing the Next Frontier’, discusses the economic and demographic fundamentals in favour of frontier markets, which point to higher growth for decades to come. Frontier markets have twice the projected employment growth of emerging markets and five times that of developed markets. They also have a 50 per cent greater growth rate in urbanization than emerging and only slightly higher debt:GDP ratios (still a lot less than developed countries). Less well known among investors is probably the make-up and behaviour of the index.
Financials are by far the biggest industry sector in the frontier index, making up 49.16 per cent by capitalization as of June 2014. This is because many frontier countries were built around oil and natural resources and created a banking sector to support those industries.
Oil and gas make up 10.79 per cent of the index and industrials 9.88 per cent. However, the second biggest sector is consumer goods, with 11.82 per cent. There are 46 consumer goods stocks and 26 consumer services stocks in the FTSE frontier index.
The paper says: “Energy stocks are often thought to be a main driver of these markets, but frontier energy companies tend to be state owned. As a result, energy actually represents only a modest portion of frontier indices. In fact, the biggest opportunity may come from the consumer sector as growing populations and low labour costs, which lead to manufacturing jobs, create an emerging middle class available to purchase goods.”
Recent performance for frontier stocks has also been a lot better than emerging. The three-year annual return, to December 2013, for the frontier index is 3.16 per cent compared with minus 2.61 per cent for emerging. The one-year return for frontier was 25.78 per cent, versus minus 2.93 per cent for emerging. And frontier markets had lower volatility than either emerging or developed markets – 10.79 per cent over three years versus 16.69 per cent for developed markets and 19.49 per cent for emerging markets.
The paper points out that economic growth does not always translate to good performance for financial markets, especially when there is an abundance of state-owned enterprises and a large presence by multinationals.
There is also often political and social instability, restrictions on foreign portfolio investment and exchange controls.
There is also less liquidity. The average daily traded value of the frontier index last year was US$589 billion compared with US$9.21 trillion for emerging markets and $18.06 trillion for developed markets. It is possible that the surprisingly low volatility in frontier markets is caused by illiquidity, even though FTSE screens participant stocks for free float.
