Emerging Markets are so Passé. Time to Start Thinking About Frontier Markets!

Frontier marketsIf you haven’t heard of frontier markets yet, get ready, as this area is the popular new kid on the block! Basically, frontier markets are the smaller, lesser-known cousins of emerging markets. Think: Kuwait, Nigeria, Argentina, Pakistan, Kenya, Morocco, and more. These are countries that are at an earlier stage of development relative to emerging markets countries (e.g. Brazil, Russia, India, China, etc.) and in general, are entering a period of strong expected growth due to favorable demographics, infrastructure spending, and an improving business environment.

Although one may think because they are less developed that they’d be more volatile, a recent study by LR Global showed that they are not. In fact, they are not as volatile as emerging markets or even developed ones! Part of this has to do with their limited exposure to the global financial system. Up until just recently, there hasn’t been much public access to these markets. As such, because they have seen lower inflows of foreign capital, they are generally less affected by what goes on elsewhere.

Another thing to be excited about is the diversity of the frontier countries’ economies and market drivers. Hence, they have low correlations with one another… and low correlations with everything else in your portfolio.

So back to the school blackboard: Does anyone recall why low correlations are good? I know some of you may be tired of hearing me repeat this constantly, but it’s important…

Low correlations produce a smoothing effect to your overall portfolio returns,

which minimizes downside, and ultimately leads to better long-term results.

At DWM, we believe frontier markets should receive a minority allocation (2-5%) of a client’s overall equity exposure. And we use the iShares MSCI Frontier 100 ETF (symbol: FM) to get it. This ETF tracks the MSCI Frontier Markets 100 Index. Constituents of the MSCI Frontier 100 Index have to meet minimum liquidity thresholds. Typically, FM will hold about 100 underlying securities, thus providing ample diversification. There are a few other frontier markets options out there, but we believe FM currently represents the only frontier ETF market play with appropriate liquidity. As an extra bonus, it carries a much lower expense ratio (0.79%) than its actively managed peers. Return-wise, it has been putting up attractive numbers, up over 16% YTD at the time of this writing, and up about 50% since the start of 2013. We are cautiously optimistic that this type of solid performance can continue.

If you seek exposure to the next group of countries that are both primed for rapid economic expansion and can potentially provide diversification to your overall portfolio, FM is the ETF for you.

If you have any questions about frontier markets or other investment styles, don’t hesitate to contact us.

Don’t Neglect the Emerging Markets

From The Charleston Mercury, February 7, 2013:

financial advisors, asset allocation

Yes, 2012 was a great year for U.S. equities. The S&P 500 index rose 13%. However, did you know that the MSCI Emerging Markets Index was up 15%? Emerging market results were uneven. Turkey and Thailand had exceptional performance. China and India did well. Chile and Indonesia did poorly.

Bond returns in the U.S. were lower in 2012; the U.S. Aggregate bond index was up 4%. Not so with emerging market bonds. The JP Morgan Emerging Market Bond Index returned 18% in 2012 (11% per year in the last decade.) Even countries like Mongolia, Zambia and Bolivia are issuing sovereign bonds and receiving favorable terms. The world is changing every day.

You and your financial advisor should consider including emerging markets as a small part of your diversified core portfolio of stocks and bonds. Here’s why:

The demographics are great in the emerging countries. They have an expanding middle class, low debt to GDP and improving credit quality. Growth prospects in emerging countries are much better than developed countries. The IMF forecasts an increase in GDP in emerging markets from 5.3% in 2012 to 5.5% in 2012. Developed countries will likely be around 1%. 

An additional reason for considering an allocation to emerging market stocks includes current valuations. Emerging market stocks are selling for around 12 times earnings for the past 12 months versus roughly 16 times for S&P 500 stocks. 

Emerging market bonds are certainly a more risky investment than the bonds that compose the U.S. Aggregate bond index; which is roughly 2/3 U.S. treasuries and agencies and 1/3 corporates. With a credit quality rating generally comparable to high yield bonds, emerging market bonds would be expected to produce a higher return. However, some of the emerging market countries are stabilizing and, in fact, receiving upgrades in their government bond ratings, while the ratings of some developed countries are being downgraded.

Certainly, there are risks with emerging market securities. First, we are interconnected in the global economy. When growth stagnates in mature countries, this has a direct impact on emerging markets. Second, emerging market stocks and bonds are more volatile. During the last bear market from April, 2011 to October, 2011, the MSCI Emerging Market Index plunged 28%, while the S&P 500 index dropped 19%. In a flight to safety, both emerging market stocks and bonds will likely fare worse than domestic stocks and bonds.

Even so, don’t neglect to allocate a small part of your portfolio to emerging market securities. Over the long-term, you should be well rewarded for your foresight and incurring slightly more risk on a small portion of your portfolio.

Les Detterbeck is one of a small number of investment professionals in the country who has attained CPA, CFP®, and CFA designations. His firm, DWM Financial Group, Inc., a fee-only Registered Investment Adviser, has offices in Charleston/Mt.Pleasant and Chicago. Les may be contacted at (843)-577-2463 or les@dwmgmt.com