(PUB) Investing 2015

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Frontier Markets Begin to Emerge Morningstar Research | Patricia Oey

financial crisis, the MSCI Frontier Markets Index had a maximum drawdown of 66% , greater than the MSCI Emerging Markets Index’s 58% . Recent declines in commodity prices may prompt selling pressure in frontier markets, as many countries in the Middle East and Africa are commodity exporters. But when looking at other measures of risk, frontier markets tend to fare better. Partly because of lower levels of integration with the global economy, each frontier-markets country tends to have more idiosyn- cratic risks, with individual equity markets historically exhibiting low correlations with one another. As a result, the MSCI Frontier Markets Index has been less volatile (as measured by the rolling three-year annualized standard deviation of returns) than the MSCI Emerging Markets Index. As for diversification benefits, frontier markets have been less correlated to U.S. equities relative to emerging markets. Recent Performance One reason frontier-markets equities are gaining interest is their outperformance versus emerging markets in the past couple of years. This is often attributed to frontier markets’ rosier growth outlook relative to emerging markets, especially as the larger economies such as China, Brazil, and Russia have begun to slow. However, a closer look reveals that frontier markets’ recent performance reflects a confluence of factors— some fundamental, some not, and many that are specific to frontier-markets equities. An examination of some of these factors will help illustrate the notable idiosyncrasies and challenges related to investing in frontier markets. During the past two years, the best-performing frontier markets have been United Arab Emirates, Argentina, and Kenya. The capitalization-weighted MSCI indexes (in U.S. dollars) for each of these countries returned 47% , 41% , and 35% , respectively, for the two-year period (annualized) through December 2014 . These returns contributed to the MSCI Frontier

Frontier markets represent a tiny segment of the global investment universe, but interest in the asset class has been growing as investors search further afield for better growth opportunities and pursue new ways to diversify their portfolios. Frontier markets, by definition, are at the far edge of the investment universe and are generally not included in global-equity indexes or in most emerging- markets equity funds. This is because frontier capital markets are not easily accessible. These markets tend to have a small number of liquid securities and restrictions on foreign ownership. Investors mulling the merits of this investment frontier should take a closer look before jumping in: The underlying risks and performance drivers are quite different from those in emerging and developed equity markets. Surveying the Frontier The frontier-markets universe is typically composed of stocks listed in Africa, the Middle East, former Soviet Republics, and less-developed Asian countries such as Pakistan, Vietnam, and Bangladesh. The investment case for these countries is enticing— many are entering a period of mid- to high-single-digit growth, thanks to a very low economic base, favor- able demographics, growth in infrastructure spending, and, in some cases, abundant natural resources. In addition, some countries will benefit from the rapid adoption and dissemination of “new economy” services such as mobile banking and mobile payments. The risks of investing in frontier markets are many, including political instability, social unrest, corruption, disease, terrorism, underdeveloped financial systems and capital markets, and a fickle regulatory environment. Most importantly, during periods of extreme market stress, frontier markets’ relatively illiquid stock markets can suffer sharp declines in the face of heavy selling. During the 2008 global