I’ve written before about how a boom in emerging market stocks is not a question of “if” but “when.” Catch a boom in an emerging market — India is a solid candidate for 2014 — and you can easily double or triple the returns you get from just sticking with mainstream U.S. stocks.
There is, however, a way to boost your returns even more by investing in so-called “frontier markets” — developing markets that are even smaller and more illiquid than their emerging market cousins.
Surprisingly, frontier markets may also offer the better long-term investment opportunity.
Certainly, it has been that way over the past few years.
Yesterday, the MSCI Frontier Index closed at a record high, and it is up 18.22% in 2014.
That has far outpaced the MSCI Emerging Markets Index’s return of 9.07%, as well as the S&P 500’s return of 7.98%.
This strong performance continues a recent trend. The MSCI Frontier 100 Index was up 25.9% in 2013, outperforming the MSCI Emerging Markets Index by 28.5%.
Frontier Markets: The Investment Case
Strong economic growth, diversification and superior returns with lower volatility combine to make frontier markets a very attractive investment.
Invest in a successful market at the start of its emergence — as investing legend John Templeton did with both Japan and Germany after the Second World War — and you have the formula to generate big and lasting returns for many years to come.
High Economic Growth
Even as the pace of development in large emerging markets like China and Brazil slows, frontier markets are just now entering a period of mid- to high-single-digit percentage economic growth.
This process is driven by the same factors that lifted economic growth in emerging markets: favorable demographics, massive infrastructure spending and a shift in economic policies that signals to the world that a country is now “open for business.”
Frontier markets also offer diversification in ways that emerging markets no longer do. That’s because they are one of the very few asset classes that don’t move in lockstep with global stocks. Because the MSCI Frontier Emerging Markets Index invests in places off most investors’ maps — think Kuwait and Nigeria — frontier markets march to the beat of a different drum. That explains why iShares MSCI Frontier 100 ETF’s (FM) five-year correlation coefficient to the S&P 500 is only 0.63.
Perhaps even more surprisingly, the MSCI Frontier Markets Index has been also less volatile than the MSCI Emerging Markets Index and the S&P 500 over the past 15 years. In fact, frontier markets’ volatility, or “beta,” is only 0.71. That means it is actually less volatile than the S&P 500 itself.
How do you explain this counterintuitive result?
Sure, political instability, social unrest, widespread corruption and a fickle regulatory environment can make individual frontier markets more volatile than traditional emerging markets. At the same time, individual frontier countries have low correlations with each other. As a result, owning a basket of frontier market investments often leads to a much less volatile overall investment.
‘Frontier Markets’ Redefined
This is a watershed year for frontier markets — and it’s not just because of their strong performance.
A large part of the MSCI Frontier 100 Index’s strong performance since early 2013 has been thanks to its high weighting to stocks in the United Arab Emirates (UAE) and Qatar. These two markets have been among the top-performing stock markets in the world in both 2013 and 2014.
There are, however, big changes afoot. In late May, both the UAE and Qatar were upgraded from “frontier markets” to “emerging markets.” Many investors had criticized the MSCI Frontier 100 Index for having too high of a concentration on the wealthy Gulf States. After all, the Gulf States are the oil- and gas-rich Arab countries, some of whose per capita gross domestic product (GDP) exceeds that of the United States.
Up until very recently, the Gulf States comprised about 60% of the MSCI Frontier 100 Index — 20.58% in Kuwait, 19.03% in Qatar, 17.52% in the UAE and 3.46% in Oman. But this figure will fall to about 35% after Qatar and UAE move out of the index.
Once the transition is complete, the allocations will look very different from what they are today.
Kuwait will continue to be the largest country allocation after the index change. Nigeria will become the index’s second-largest holding. The next two countries represented in the new index — Argentina and Pakistan — were both downgraded from their former emerging markets status.
The changes in the MSCI Frontier 100 Index will result in greater geographic diversification. Overall, the new index will reflect more accurately what most investors think of as frontier markets.
Frontier markets also will become cheaper. Both the Qatar and UAE stock markets soared in anticipation of their promotion to emerging markets and trade at price-to-earnings (P/E) ratios of over 20. In contrast, Nigeria trades at a P/E of 9. Several other constituents of the frontier index also trade at big discounts to the MSCI Emerging Markets Index.
The bottom line?
With global investing making a comeback after five very lean years, I believe there is big potential upside in frontier markets during the next 12 months.
As my Alpha Investor Letter subscribers know, the single best way to invest in frontier markets is through the iShares MSCI Frontier 100 (FM) exchange-traded fund (ETF). The iShares MSCI Frontier 100 (FM) is also the strongest single performer in my firm Global Guru Capital’s “Global Gains” Investment Program.
NOTE: Global Guru Capital is a Securities and Exchange Commission-registered investment adviser, and is not affiliated with Eagle Financial Publications.
In case you missed it, I encourage you to read my e-letter column from last week about this year’s most profitable global stock markets. I also invite you to comment in the space provided below.