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This is the submitted version of the following article:

Frontier Equity Markets

A Primer on the Next Generation of Emerging Markets

Which was published in final format in the Winter, 2010 Edition of:

The Journal of Wealth Management

Winter 2010, Vol. 13, No. 3: pp. 50–58DOI: 10.3905/jwm.2010.13.3.050

http://www.iijournals.com/doi/abs/10.3905/jwm.2010.13.3.050

Clifford Quisenberry Jr., CFA

Chief Investment Officer in Tacoma, Washington

Benjamin Griffith, CFA

Analyst in New York, New York

Caravan Capital Management LLC

www.caravancap.com

Email: cliffq@caravancap.com

Tel: (253) 230 - 9011

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Over the last several years, the continued integration of world economies and capital

markets has caused a convergence in the behavior of equities around the world. This process

has led many of the larger emerging markets to behave increasingly like developed markets in

terms of valuations and their correlations to other markets. Global investors looking to further

enhance diversification and capture the potential of rapidly developing economies with

compelling valuations have begun to look for the next generation of emerging markets. A

loosely defined class of countries has emerged under the popular buzzword, “frontier” markets.

In this paper we provide an introduction to these markets; examining how they are defined and

the characteristics that differentiate them from the standard emerging markets.

Defining the Frontiers

Unlike the emerging markets, defining which countries constitute the frontier markets

can be challenging. While the two major index providers for the emerging markets, Standard

and Poor’s and MSCI, provide fairly objective criteria for defining the emerging markets, their

approach to the frontier markets seems more subjective. For example, in their country and

company inclusion criteria for the emerging market indices, MSCI and Standard & Poor’s set

minimum market capitalization and volume levels after adjusting for each securities’ free float

and foreign ownership restrictions. However, while S&P looks at these factors for determining

country inclusion in their S&P Frontier BMI Index, they do not apply set minimums or

maximums and instead state that consideration of frontiers is based upon, “a market’s

turnover, number of listings, and whether it has attracted a minimum amount of foreign

investor interest… [as well as]…a market’s development prospects…”i In addition to the factors

of size and liquidity, MSCI also looks at the stability of political and economic conditions,

including only markets in their frontier index “…that do not belong to countries undergoing a

period of extreme economic and political instability.”ii By the fact that they were excluded from

the emerging market indices, this means frontiers typically have relatively low market

capitalizations and trading volumes, have local financial regulations that discourage investment

by foreigners, or simply do not have sufficient data available to warrant inclusion in an

emerging market index.iii

Not surprisingly, frontiers are typically poor as defined by GDP per capita. Many frontier

countries have also endured periods of political or economic instability as well as political

mismanagement which historically may have prevented them from obtaining emerging market

status. Yet this is not always the case, and thus, using these criteria to discriminate among

frontier markets can be misleading. By the IMF’s 2008 rankings, one of the richest countries in

the world is a frontier, Qatar, with over $91,000 in USD GDP per capita.iv Some frontier

countries score relatively well in terms of combating corruption or maintaining political

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stability, especially Estonia, Slovenia, and Uruguay.v Many frontiers are frontiers simply

because they are small.

A more straightforward method is to define a frontier market country as any country

which has publicly traded companies on an exchange but is not a member of both the MSCI and

S&P emerging indices and not a member of any developed market index. Using this

methodology, there are 85 frontier countries in the world (see Exhibit 1). These 85 countries

translate into 78 unique stock markets, which include two regional stock exchanges. Of these

markets, currently 36 are members of the S&P Frontier BMI Index or the MSCI Frontier Markets

Index (shown in bold). We define the remaining 42 markets that are not members of the

frontier indices as “exotic” frontiers and for purposes of this paper have constructed a market

capitalization weighted index of 20 of these markets excluded from the frontier indices.vi

Exhibit 1

Europe Latin America Sub-Saharan Africa MENA Asia

Armenia Argentina Benin Bahrain Bangladesh

Azerbaijan Barbados Botswana Iran* Kazakhstan

Belarus Bolivia Burkina Faso Iraq Kyrgyz Rep.

Bosnia Colombia Cameroon Jordan Maldives

Bulgaria Costa Rica Cape Verde Kuwait Mongolia

Croatia Dominica Cote d'Ivoire Lebanon Nepal

Estonia Ecuador Ghana Libya Pakistan Georgia El Salvador Kenya Oman P. New Guinea

Latvia Grenada Malawi Palestine Fiji

Lithuania Guyana Mauritius Qatar Sri Lanka

Macedonia Jamaica Mozambique Saudi Arabia Uzbekistan

Malta Panama Namibia Sudan* Vietnam

Moldova St. Kitts and Nevis Niger Syria

Montenegro St. Lucia Nigeria Tunisia Republika Srpske Trinidad and Tobago Senegal UAE Romania Uruguay Swaziland Serbia Venezuela Tanzania Slovakia

Togo

Slovenia Uganda Ukraine Zambia Zimbabwe

vii

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Geographic and Sector Exposures

One of the obvious characteristics of the universe of frontier markets is its geographic

diversity, spanning nearly every region found for the standard emerging markets but with some

prominent additions. The Persian Gulf countries, the Balkans, the Baltics, Central America,

Central Asia, East and West Africa, and the Caribbean are eight regions represented by frontier

markets not found in standard emerging markets.

Exhibit 2

Index Weights by Sub-Region

Sub-Region Major Region S&P Frontier BMI S&P/IFCI

Southern Africa Africa 2.1% 6.7%

East Africa Africa 1.6% 0.0%

North Africa Africa 0.7% 0.9%

West Africa Africa 9.3% 0.0%

South Asia Asia 5.1% 8.5%

Southeast Asia Asia 2.4% 5.7%

East Asia Asia 0.0% 43.1%

Central Asia Asia 6.3% 0.0%

Baltics Europe 0.6% 0.0%

Balkans Europe 2.0% 0.0%

Central & Eastern Europe Europe 3.4% 9.0%

Southeastern Europe Europe 1.1% 1.6%

Central America Latin America 2.6% 0.0%

South America Latin America 18.8% 18.0%

Caribbean Latin America 1.1% 0.0%

North America Latin America 0.0% 4.0%

Persian Gulf Middle East 36.0% 0.0%

The Levant Middle East 7.3% 2.7% viii

When inspecting the MSCI and S&P Frontier indices, it is apparent that most of their

weight is concentrated in the Middle Eastern markets (see Exhibit 2). This is a result of Kuwait

and the UAE having quite large equity markets relative to the frontiers found in other regions.

Indeed, these markets have been up for review to be included in the standard emerging market

indices.ix But frontiers have little exposure to Asia when compared to the S&P/IFCI Emerging

Markets index which is heavily concentrated in East Asia due to the large market capitalizations

of China, Korea, and Taiwan. There are sub-regions in which the frontier indices have a

significant weight of more than 4%, and in which the emerging market indices have no weight,

most notably in the Persian Gulf, West Africa, and Central Asia.

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At the sector level, frontiers also appear somewhat different than their larger

counterparts. Some of these differences are a result of their early stage of economic and

financial market development. For example, financial stocks comprise the vast majority of the

frontier market universe. While most of the equities in this category are commercial banks,

other common financial companies in the frontier markets include insurance companies, and

retail or microcredit banks. All together, financials stocks have historically comprised more

than 60% of the S&P Frontier BMI Index and more than 50% in the MSCI Frontier Index.x Exhibit

3 illustrates the differing sector exposures of the MSCI Frontier Index and the MSCI Emerging

Markets Index as of 12/31/2009.

Exhibit 3

MSCI Frontier

Index MSCI Emerging

Index Difference

Financials 53.8% 24.3% 29.6%

Telecommunication Services 17.0% 8.6% 8.3%

Energy 8.6% 14.8% -6.2%

Industrials 7.2% 6.7% 0.5%

Materials 4.4% 14.9% -10.5%

Consumer Staples 4.3% 5.6% -1.3%

Health Care 2.0% 2.2% -0.2%

Utilities 1.3% 3.7% -2.4%

Consumer Discretionary 1.1% 5.8% -4.7%

Information Technology 0.4% 13.5% -13.1% xi

Banks are often the first companies to list in nascent equity markets, as they tend to

have the greatest understanding and experience working in the capital markets and also

require a relatively large amount of capital in order to achieve the scale needed to reach

profitability and minimize risks.xii In addition, the Gulf markets are heavily weighted in

financials and this region dominates the MSCI Frontier Index. Another product of the fact that

most frontiers are at the early stages of their economic development is their relatively low

weight in the sectors of health care and information technology. Many frontier economies,

most notably in the Persian Gulf, Africa, and Latin America, are endowed with abundant natural

resources, which often make up a large percentage of GDP and may provide the bulk of foreign

currency receipts.xiii However, the companies that directly own or control these national

resources are often considered strategic national assets and remain state owned, and thus are

understated in terms of their index weight. Despite this, commodity prices tend to drive

corporate earnings indirectly through overall GDP growth, as well as the relative strength of

many frontier currencies. As a result, the returns of the frontier market indices are heavily

correlated with crude oil and copper spot price returns. In a regression the individual

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correlation coefficients between the annualized returns of the MSCI Frontier Index and the

annualized spot price returns of West Texas Instrument Crude Oil and London Metals Exchange

Copper were 0.51 and 0.32 respectively for the 10 years ending 11/30/2009. While investing in

the frontier markets can provide an indirect hedge against inflation for investors based in the

developed world, commodity price fluctuations are also a cause of return volatility.

Liquidity on the Frontier

Chief among the factors affecting investment in the frontier equity markets is the

relative lack of liquidity. The average monthly total dollar volume for the frontier markets was

substantially lower than the standard emerging markets in a study over the most recent 6

month period (see Exhibit 4).xiv While over $560 billion of securities traded per month for the

emerging markets, only $33.7 billion traded for the frontier markets. However, even this large

disparity is deceiving as most of that volume came from the much more liquid Gulf countries.

When these countries are removed from the frontiers, total monthly volume decreases

substantially to $7.4 billion. More dramatically, the monthly volume of all exotic frontier

markets was a mere $520 million per month over this period.

Exhibit 4

xv

The relative lack of liquidity in the frontier markets in turn creates higher trading costs

because of higher market impact when transacting a trade. In addition, the lack of large trade

flows often coincides with a lack of a large number of competing brokers which can lead to

higher frontier market commission rates. Using data based upon a survey of institutional trades

from Elkins McSherry over 12 months ending June 2009, the commission for an equal weighted

$560.3

$33.7 $7.4 $0.5

$-

$100

$200

$300

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$500

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S&P Emerging BMI Plus

Standard Frontiers Standard Frontiers ex GCC

Exotic Frontiers

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basket of 21 standard emerging markets was 25 basis points. xvi Based upon a survey of frontier

broker commission rates, the commission for an equal weighted basket of 51 frontier markets

was nearly five times higher at 123 basis points. The distinction of the highest commission in

our survey belonged to Mongolia, costing over 450 basis points per trade.

Market impact as defined by Elkins McSherry using their VWAP method was about 16

basis points for the same basket of standard emerging markets.xvii Assessing market impact for

frontier markets is much more difficult as this type of analysis is almost entirely absent for

frontier markets. In addition, many exotic frontier markets lack natural trade flow on a daily or

even weekly basis, meaning transactions in these markets are virtually on a negotiated basis.

Based upon informal surveys of frontier traders and experience of the author, market impact

for a basket of frontier markets can range from 100 to 300 basis points.

Economic Growth and Stock Market Returns

Partially as a product of their underdevelopment, frontier countries have experienced

rapid economic growth, especially in recent years. Countries defined as being frontier equity

markets generally fall into two economic categories: sources of raw materials for export to the

rich world, and low cost suppliers of labor. Both of these economic models have been broadly

successful throughout the recent decades of globalization, and frontier countries have

experienced more rapid economic growth than emerging or developed countries. The cheap

transfer of new technologies from the rich world to the developing world is also a key factor in

the frontiers’ achievement of rapid economic growth. This thesis is supported by the historical

and forecasted real GDP growth rates of the frontiers as compared to emerging and developed

countries (see Exhibit 5).

Exhibit 5

xviii

-4.0%

-2.0%

0.0%

2.0%

4.0%

6.0%

8.0%

20

03

20

04

20

05

20

06

20

07

20

08

20

09

20

10

e

20

11

e

20

12

e

20

13

e

20

14

e

20

15

e

Average Annual GDP Growth by Category

Frontier Emerging Developed

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Given their relative lack of liquidity and size, as well as their unique political and

economic risks, frontier equity markets should be expected to have relatively high risk

premiums and command higher expected market returns, all other things being equal. These

higher expected returns are generally reflected in terms of lower valuations, such as lower price

to earnings ratios for frontier markets as compared to the emerging markets. Exhibit 6

illustrates the simple average of trailing P/E ratios for the country members of the MSCI

Frontier Index vs. the country members of the MSCI Emerging Markets Index as of 4/30/2010.

Exhibit 6

xix

Yet these lower valuations may not be wholly justified by this perception of risk, based

on one important observation; many frontier equity markets are still dominated by local market

participants who rationally demand higher returns to compensate for the country specific risk

they experience. However, from the perspective of global investors, much of this country

specific risk should be effectively reduced through diversification within a global portfolio.

Modern portfolio theory would suggest that frontier markets have expected returns that are

set unduly high for the risk they actually endure.

Actual historical returns of frontier markets as compared to emerging markets have

been similar. Over the 10 years ending 4/30/2010, the MSCI Frontier Index returned 12.5% per

year, versus the MSCI Emerging Markets performance of 12.7%, and the S&P 500 return over

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Country P/E of Frontier vs. Emerging Markets

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MSCI Frontier Index: 11.8x

MSCI Emerging Markets Index: 14.8x

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the same period of -0.2%. An index of 20 of the more exotic frontier markets excluded from

the MSCI and S&P Frontier Indices returned an average of 10.3% per year in the seven years

since its inception ending 4/30/2010, versus the same 10.3% per year for the MSCI Frontier

Index over the same period.xx

Correlations to Each Other and to the Developed Markets

One attractive characteristic of the frontiers is their low cross correlations (the average

of all the pair wise correlations of the returns of the frontier markets to each other). Given the

observation that frontier markets are on average more influenced by country specific risk, we

would expect frontier markets to exhibit lower cross correlations. In general, what happens in

Malawi has virtually no impact on what happens in Armenia or Mongolia or Costa Rica.

However, the same cannot be said for the impact of an emerging market on other emerging or

developed markets. Certainly, what happens in China affects Korea, Brazil, and the United

States. In this regard, the frontiers lack of integration with the world financial system is a

blessing to long-run minded professional investors. The kinds of market linkages witnessed in

South-East Asia during the Asian crisis of the late ‘90’s have yet to materialize to the same

degree in the frontier equity markets. In the five years ending 4/30/2010, the emerging

markets averaged a cross correlation of 0.64, while the standard frontiers averaged 0.28, and

the exotic frontiers averaged a mere 0.07 (See Exhibit 7).xxi

Exhibit 7

Correlation Coefficients 5 Years 10 Years

Cross

Correlation Correl to S&P 500

Correl to S&P Euro 350

Cross Correlation

Correl to S&P 500

Correl to S&P Euro 350

Exotic Frontiers 0.07 0.34 0.09

MSCI Frontiers 0.28 0.64 0.73 0.22 0.52 0.63

S&P IFCI Emerging 0.64 0.76 0.89 0.50 0.78 0.83

xxii

These low correlations across markets help to dramatically reduce portfolio level

volatility in a diversified index or portfolio of frontier markets.

For many of the same reasons that they exhibit low cross correlations, frontier equity

markets also exhibit low correlations to the major world markets, including the US and

European markets. Frontier markets exhibit significantly lower correlations to the developed

markets than do the emerging markets because their economies and financial systems are less

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integrated and therefore relatively less dependent on capital and demand from the rich

countries. This provides an added benefit of diversification to the total portfolio of US,

European, and other investors based in the developed world. Exhibit 8 highlights the low

correlation of the frontiers versus the S&P 500 Index relative to other market categories, using

running 48 month periods, ending 4/30/2010.xxiii

Exhibit 8

Another aspect of correlations across market classes that stands out in Exhibit 8 is the

increase in correlations caused by the global financial crisis beginning in October of 2008. This

trend is consistent with past global market crises, and is clearly detrimental to the cause of risk

reduction through international diversification. However, this phenomenon occurred across

almost all asset class categories, and the frontiers remained significantly less correlated to the

US market than other market categories, especially the exotic frontiers, even in the depths of

the crisis.

Country Volatility and Index Volatility

Individually, frontier equity markets exhibit volatility that on average is similar to the

standard emerging markets. Looking at the annualized standard deviation of country returns

for the 10 years ending 4/30/2010, the average frontier country’s volatility stood at 30.5% vs.

31.5% for the average emerging market country, and 16.2% for the S&P 500. The more exotic

frontier markets exhibited lower volatility, as illustrated in Exhibit 9.

Given the similar volatility at the country level, the low correlations between the

frontier markets theoretically should help to reduce the volatility of a portfolio or index of

-0.50

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Correlation to the S&P 500Running 48 Month PeriodsJanuary 1996 to April 2010

Exotic Frontiers = 0.38

MSCI Frontiers = 0.69

S&P IFCI Emerging = 0.83

S&P Dev. BMI ex US = 0.92

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frontier countries because of the benefit of diversification. This difference between average

country volatility and the lower volatility of the index of these same countries is readily seen in

Exhibit 9. This effect is particularly noticeable when looking at the most exotic frontier

markets, due to the exotic markets having the lowest cross correlations.

Exhibit 9

Annualized Volatility 5 Year 10 Year

Average Country Index

Average Country Index

Exotic Frontiers 27.3% 10.0%

MSCI Frontier Index 30.3% 25.3% 30.5% 19.1%

S&P IFCI Emerging 30.9% 27.5% 31.5% 24.7%

S&P 500 Index 17.0% 16.2% xxiv

While the trend has been for cross correlations and volatility to rise in recent years,

peaking during the crisis of 2008, the frontier markets still have relatively lower volatility than

the emerging markets. It is worth noting that the index of 20 exotic frontier markets excluded

from the frontier indices had lower volatility than the S&P 500 over the last 5 years.

Conclusion

As a group, the frontier equity markets have displayed similar long-run returns and

economic growth prospects with slightly lower volatility than the emerging markets over the

last 10 years. In addition, their low cross correlations mean broad and diversified portfolios of

frontier markets can produce lower volatility than their larger emerging market counterparts.

Finally, frontier markets generally offer lower correlations to the developed markets. This

combination of high expected returns and lower volatility mean frontier markets should be

viewed as suitable additions to global portfolios.

This paper is intended to be an introduction to the frontier equity markets, and many

areas are left open for further discussion. For example, the relationship between market size,

liquidity and market volatility and the correlation to other markets warrants additional study.

To the extent that a frontier market’s low volatility and correlation is simply a product of their

small size and lack of liquidity would limit the ability of portfolio managers to achieve the full

benefits of diversification in practice. However, the typical frontier country’s lack of financial

integration with the rest of the world and the relative importance of country specific factors in

driving stock market returns suggest that frontier markets should fundamentally have lower

correlations than standard emerging markets.

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In many ways, the frontier emerging equity markets look similar to the way the

emerging markets did 20 years ago. Rapid economic growth and elevated risk premiums

provide opportunities for attractive long-run returns, and diversifiable country risks allow for

relatively low portfolio level volatility in a balanced portfolio. Furthermore, the frontiers’ low

correlations to the developed markets provide significant diversification benefits to

international portfolio investors.

i S&P Frontier BMI Factsheet. Standard & Poor’s. The McGraw-Hill Companies. (2009): 1. Web. http://www2.standardandpoors.com/spf/pdf/index/SP_Frontier_BMI_Factsheet.pdf . ii MSCI Barra Global Investable Index Methodology. MSCI Barra. (2010): 47. Web.

http://www.mscibarra.com/eqb/methodology/meth_docs/MSCI_Jan10_GIMIMethod.pdf. iii S&P Frontier BMI Factsheet. Standard & Poor’s. The McGraw-Hill Companies. (2009): 1. Web.

http://www2.standardandpoors.com/spf/pdf/index/SP_Frontier_BMI_Factsheet.pdf . iv

IMF World Economic Outlook. IMF. Database: April, 2010. Web. http://www.imf.org/external/pubs/ft/weo/2009/01/weodata/index.aspx v Corruption Perception Index. Transparency International. 2009. Web.

http://www.transparency.org/policy_research/surveys_indices/cpi/2008 vi

Our index of 20 exotic frontier markets is market capitalization weighted, with a country weight constraint applied of two times 1/n, where n is the number of markets. The markets included were selected due to the regular availability of pricing data needed to construct the index. The countries included in the index as of 4/30/2010 include: Armenia, Barbados, Bosnia Herzegovina (Sarajevo Stock Exchange), The Eastern Caribbean Securities Exchange, El Salvador, Fiji (The South Pacific Stock Exchange), Guyana, Iraq, Malawi, Maldives, Moldova, Mongolia, Nepal, Palestine, Panama (Bolsa de Panama), Papua New Guinea, Tanzania, Uganda, Uruguay, and Uzbekistan. vii

Italicized = countries covered by a regional stock exchange, including the BRVM in West Africa and the ECSE in the Caribbean. Bold = members of MSCI and/or S&P Frontier indices * = Markets unavailable to US investors. viii

S&P Index weights provided by Standard & Poor’s. Previous year’s index weights available at: S&P Frontier BMI Factsheet. Standard & Poor’s. The McGraw-Hill Companies. (2009): 1. Web. http://www2.standardandpoors.com/spf/pdf/index/SP_Frontier_BMI_Factsheet.pdf . ix Brandimarte, Walter. “MSCI ups Israel to developed mkt; mulls Korea, Taiwan.” Reuters. June 15

th, 2009. Web.

http://www.reuters.com/article/idUSN1524411720090615 x S&P Frontier BMI Factsheet. Standard & Poor’s. The McGraw-Hill Companies. (2009): 1. Web.

http://www2.standardandpoors.com/spf/pdf/index/SP_Frontier_BMI_Factsheet.pdf . xi Bloomberg Terminal Service. MSCI Frontier Market Index and MSCI Emerging Market Index weights. 12/31/2009.

xii Quisenberry, Clifford Jr. and Griffith, Benjamin. Banking on the Frontier. Caravan Capital Management, LLC. March, 2009.

Contact us to request a copy. xiii

Based on data from the EIA and the IMF World Economic Outlook Database for 2008, several frontier markets economies, including Saudi Arabia, Kuwait, Oman, Nigeria, and Venezuela show net export of crude oil / GDP ratios greater than 50%. xiv

Monthly Total Volume is calculated as the total of the 12 month average of all dollar value traded ending 12/31/2009 for

companies in each category. The Emerging Markets are defined as markets included in both MSCI and S&P Emerging Market

Indices. The Standard Frontier Markets are defined as markets included in either the MSCI or the S&P Frontier Index. The

Exotic Frontier Markets are defined as all markets excluded from developed, emerging, and frontier indices of both the MSCI

and S&P for which data was available. Data for the Emerging Markets and Standard Frontier Markets was gathered from

Bloomberg. Data for the Exotic frontier markets was gathered manually from data from local stock exchanges. xv

Value traded data for The S&P Emerging Markets BMI was provided by Standard & Poor’s. The value traded data for the Standard Frontiers and Exotic Frontier Markets were calculated based on the entire universe of countries in each category using data from Bloomberg. xvi

Survey of Trading Costs. Elkins McSherry. June, 2009.

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xvii

VWAP is the average trade price weighted by the volume traded over the period. VWAP is often used as a benchmark for assessing execution. Pricing and volume data can be used to assess how the size of an individual trade affects the pricing achieved relative to VWAP. xviii

Calculated as the average of the real GDP growth rate of countries within each category using data from the IMF World Economic Outlook database, updated in April of 2010. IMF World Economic Outlook. IMF. Database: April, 2010. Web. http://www.imf.org/external/pubs/ft/weo/2009/01/weodata/index.aspx xix

P/E data provided for the MSCI Frontier and Emerging country indices by Bloomberg. xx

Returns data gathered from MSCI and S&P. Data for the 20 exotic markets was collected manually. xxi

Cross correlations calculated using a simple average of each pair of country-level returns for the S&P country indices, as well as a 20 member index of countries excluded from the S&P and MSCI frontier indices to represent the Exotic Frontiers category. xxii

Correlations calculated using monthly returns for the time periods specified. Data gathered from MSCI and Standard & Poor’s. xxiii

S&P and MSCI index data provided by Bloomberg Terminal Service. Quisenberry, Clifford Jr. and Griffith, Benjamin. Neglected Frontier Index Report. Caravan Capital Management, LLC. December, 2009. Contact us to request a copy. xxiv

Volatility calculated as annualized standard deviation of monthly returns over the period specified. Data gathered from MSCI and Standard & Poor’s.

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