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Frontier Markets’ Outperformance To Extend To 2015? – Morningstar
Aspire, Hot Picks | 18 January 2015
By: Morningstar

In part 1 of this article, we looked at the composition of the frontier markets. In part 2, we look at the recent performance of the frontier markets.

Recent Performance
One of the main reasons frontier-markets equities are gaining interest among certain investors is their outperformance versus emerging markets over the two years through October 2014. This is often attributed to frontier markets’ rosier growth outlook relative to emerging markets.

However, frontier-markets equities’ calendar returns over the longer term have been more sporadic. Frontier markets underperformed emerging markets during six out of the past 10 calendar years.

A closer look reveals that frontier markets’ recent outperformance reflects a confluence of factors–many that are specific to frontier-markets equities.

Over the past two years, the best-performing frontier markets have been Argentina, United Arab Emirates, Kenya, and Qatar. The capitalization-weighted MSCI indexes (in U.S. dollars) for each of these countries returned 67 percent, 57 percent, 34 percent, and 27 percent, respectively, over the two-year period (annualized) through October 2014.

These markets contributed to the MSCI Frontier Markets Index’s return of 24 percent over the same time period.

One of the key drivers of performance in Qatar and United Arab Emirates’ equity markets was MSCI’s announcement in June 2013 that it was going to move both countries from the MSCI Frontier Markets Index to the MSCI Emerging Markets Index in June 2014. That change means there is now a significantly larger potential investor base for these new emerging-markets countries.

In addition, any investment product that tracks the MSCI Emerging Markets Index had to buy the index constituents from those countries when MSCI implemented the change in June 2014. In the months following the 2013 announcement, both domestic and foreign investors piled into Qatari and United Arab Emirates stocks in an attempt to get ahead of this reclassification.

This surge of assets into these small capital markets—each of which has about 20 liquid stocks—fuelled a strong rally. Some positive fundamentals in these markets also contributed to the momentum. Banks and property companies, which dominate each country’s index, rallied thanks to recovering real estate prices and rising infrastructure spending.

Since Qatar and United Arab Emirates had each accounted for about 15 percent allocation in the MSCI Frontier Markets Index prior to their move to the MSCI Emerging Markets Index, their market rallies contributed to the strong performance of the MSCI Frontier Markets Index through June 2014.

Argentina takes up approximately 6 percent of the MSCI Frontier Markets Index, is actually a G-20 nation and considered an upper middle-income economy by the World Bank. But due to the failure of its practices, and strict capital controls, MSCI classifies the country as a frontier market.

FTSE, which decided to take a more hard-line approach, announced in September 2014 that it will remove Argentina from its frontier index in June 2015. Argentina’s 48 percent return in the past 12 months through October 2014 may be surprising given the country’s recent debt crisis, double-digit inflation, and weakening currency.

One explanation is that local investors have been buying shares as a hedge against inflation. Another possibility is that investors are optimistic that a new leader will implement much-needed reforms that will stabilise Argentina’s economy. This might have some merit, as “reform rallies” have recently been observed in countries such as India and Indonesia.

But another potential reason Argentinians have been buying equities is because it is reportedly one of the few channels by which they can gain access to the U.S. dollar. Many large-cap Argentinian companies have both a local listing as well as an ADR that trades on the NYSE, so Argentinian investors can buy local shares and then sell ADRs for U.S. dollars.

Kenya has recently been a frontier-markets success story. Kenya is the largest economy in East Africa. Relative to its neighbours, it has a better-educated population, its economy is more diversified, and it has stronger trade and financial links to the rest of the world. Over the past few years, foreign direct investment has been rising, as many multinationals have sought to establish their East Africa hub in Kenya.

Frontier markets have a number of the same favourable investment characteristics that emerging markets had 20 years ago. However, the risks to investing in frontier markets are many, especially the downside risk during periods of heavy selling, as frontier markets tend to be fairly illiquid. In addition, most funds are untested, as they have short track records. Investors should carefully evaluate their options.

Patricia Oey is a senior analyst covering passive strategies on Morningstar’s manager research team.

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