Commentary
August 2014
The Promise (and Perils) of Frontier Markets
By: Sandra M. Ackermann-Schaufler, CFA, Portfolio Manager, International and Emerging Markets
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Frontier markets are likely to play an increasingly important role in global equity markets in the years ahead.
Frontier-based companies enjoy access to some of the world’s fastest growing economies and populations.
We believe actively managed frontier-market exposure can benefit patient, long-term investors.
In 1960, presidential candidate John F. Kennedy, pointing
to humanity’s technological future, told an audience, “The
new frontier…a place of unknown opportunities and
1
perils…is here whether we seek it or not.” For today’s
global investor, the same might be said of frontier markets.
Frontier markets include countries with capital markets
that, while functioning, are not as developed as those of
emerging markets. They are quite diverse in their
geography, economic characteristics, and stages of
development. Their unifying characteristics are primarily
financial—while investable, they are less accessible than
most emerging markets and, in many cases, are just
opening up to foreign financial capital.
For global investors, we believe there is a compelling case
to be made for adding frontier markets to a well-diversified
portfolio. Most frontier countries are expected to undergo
faster economic growth than the rest of the world, and
many of them enjoy solid demographic outlooks.
Historically, frontier-market equities have exhibited low
correlations to other asset classes, which can enhance
portfolio diversification. Frontier markets sometimes offer
attractive valuations, as well as various market
inefficiencies that active investors may be able to exploit.
There have been positive institutional and technological
advances in many frontier-market countries, and some of
them enjoy significant endowments of natural resources.
Like any asset class, frontier-market equities present both
opportunities and risks; but in cases where they are an
appropriate addition to an investor’s portfolio, we believe
experienced professional management can add value.
Surveying the Frontier Landscape
The term “frontier markets” was coined in the early 1990s,
and frontier-market investing has steadily gained traction
since then. There are currently four major frontier stock
market indices; they are overseen by FTSE, MSCI,
Russell, and Standard & Poor’s. One notable feature that
these indexes reveal is the geographic diversity of the
index constituents. As of December 31, 2013, constituents
of the four frontier indices were located across 43
countries and five global regions, as shown in Exhibit 1.
Exhibit 1: Geographic Diversity of Frontier Markets
Sources: FTSE, MSCI, Russell, Standard & Poor’s, SEI
Countries in blue were contained in the four major frontier market indexes
as of December 31, 2013.
This diversity extends to cultures, economies and ethnic
makeup as well. Seventeen countries—Argentina,
Bahrain, Bangladesh, Bulgaria, Croatia, Estonia, Jordan,
Kenya, Lithuania, Mauritius, Nigeria, Oman, Romania,
Slovenia, Sri Lanka, Tunisia and Vietnam—were contained
in all four indices. (We refer to these as the Frontier 17 in
the following pages.) With a few possible exceptions (such
as Argentina and some central European countries), this
group includes some of the most promising frontier
markets.
Among the World’s Fastest Growing Economies
1
John F. Kennedy, “Address of Senator John F. Kennedy Accepting the
Democratic Party Nomination for the Presidency of the United States,”
speech given at Democratic National Convention, Los Angeles, July 15,
1960. Accessed at <http://www.presidency.ucsb.edu/ws/?pid=25966>.
© 2014 SEI
As a group, these 17 frontier countries have experienced
faster economic growth than most of the world since the
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1
1990s. A comparison of the group’s historic and expected
growth rates of gross domestic product (GDP) to advanced
economies is shown in Exhibit 2.
Exhibit 2: Faster Economic Growth on the Frontier
8
Frontier 17
Advanced economies
7
Percent
6
5
4
3
2
1
0
Sources: IMF, SEI
Average annual rate of real (inflation-adjusted) GDP growth for each
period; * IMF forecast as of April 2014.
A map of IMF-forecasted growth rates for 2014 also shows
the relatively strong expected performance of many
emerging, frontier and pre-frontier economies.
Exhibit 3: Fast-Growing Economies
well as attractive
inefficiencies.
valuations
and
potential
market
Although it may seem counterintuitive, the historic
correlations of frontier market performance to developed
and emerging markets have only been moderate. For
example, using monthly returns from 6/30/2004 through
6/30/2014, the MSCI Frontier Markets Index had a
correlation coefficient to the MSCI World Index of 0.64 and
to the MSCI Emerging Markets Index of 0.61. The
correlation to the fixed income Barclays Global Aggregate
Index was 0.24. (A correlation coefficient of 1.00 implies
perfect correlation between two assets’ returns; zero
implies no correlation, and -1.00 implies perfect negative
correlation.) Interestingly, the correlation coefficients
between different frontier markets, using seven years of
monthly returns through June 30, 2014, averaged only
0.39. If these dynamics continue, frontier-markets
exposure may help to enhance portfolio diversification and
improve risk-adjusted returns.
As Exhibit 4 shows, current valuations in frontier markets
are also attractive in both absolute and relative terms. As
of June, the trailing price-to-earnings (PE) ratios of the
MSCI World and MSCI Emerging Markets Indexes were
10% and 4% above their averages since July 2008,
respectively, while the PE of the MSCI Frontier Index was
14% below. Over the same time frame, the MSCI Frontier
Index PE was, on average, 82% of the MSCI World PE
and 107% of the MSCI Emerging PE. As of June, it stood
at 63% and 89%, respectively.
Exhibit 4: Attractive Valuations in Frontier Markets
World
Emerging
Frontier
40
30
Sources: IMF, SEI
IMF real GDP growth forecasts as of April 2014; darker colors indicate
faster expected growth.
20
10
In addition to faster economic growth rates, one of the
more compelling arguments for frontier markets is that,
while they already contribute significantly to global
economic activity, their representation in global equitymarket capitalization remains quite low. Assuming that
financial systems in these countries continue to develop
and deepen, and that they receive greater investor
interest, we would expect to see their market
capitalizations converge toward their contributions to
global output.
Diversification, Valuations and Market Inefficiencies
While the economic-growth dynamics of many frontiermarket countries are compelling, it’s important for
investors to look directly at the corresponding financial
markets and assets. In doing so, it becomes clear that
frontier investing can offer enhanced diversification, as
© 2014 SEI
0
2008
2009
2010
2011
2012
2013
2014
Source: Bloomberg
Monthly trailing 12-month price-to-earnings ratios of MSCI Emerging,
MSCI Frontier and MSCI World Indexes from July 2008 through June
2014.
Finally, because capital markets are still developing in
many frontier markets, they exhibit certain inefficiencies
that may result in mispriced securities and thus active
investment opportunities. For example, on most frontier
countries’ stock exchanges, average daily trading volumes
2
and analyst coverage of securities remain quite low.
2
Maria Gratsova, “Call of the Frontier Revisited,” Citi GPS: Global
Perspectives & Solutions, September 2013, pp. 33-35.
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2
These inefficiencies may provide opportunities for skilled
active investment managers to add value.
health have combined with higher fertility rates to produce
populations that are quite young overall.
Growth + Inefficiencies = Significant Potential Upside
As Exhibit 5 shows, populations in today’s major emerging
markets are expected to age steadily over the next 25
years as they converge toward advanced economies,
while the median age in 17 major frontier markets will stay
low by comparison (Exhibit 4).
Exhibit 5: Younger Populations in Frontier Markets
Advanced
BRICS
Frontier 17
45
40
Median Age
If today’s frontier markets experience an evolution similar
to that of emerging markets over the last 20 years, patient,
long-term investors might reap significant benefits. For
example, frontier markets contributed 15% to global
economic output in 2010. However, their equity markets
constituted only 3% of global equity-market value (and less
than 1% of the MSCI All Country World Index). In contrast,
emerging markets contributed 36% of global output and
constituted 24% of world market capitalization, while
developed markets contributed 48% of output and 73% of
capitalization. These figures imply that stock market values
in both frontier and emerging markets may have long-term
upside relative to developed economies, and that this may
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be particularly true in frontier countries.
35
30
25
Other measures look similarly appealing. In 2009, the
value of many frontier countries’ domestic equity markets
as a percentage of national annual economic output
ranged from below 10% to slightly above 20%. In 1989,
that figure was about 10% for two of today’s major
emerging-market countries, Brazil and India. As of 2009, it
4
was above 70% for both. We expect some of today’s
frontier markets to see similar leaps in equity-market
capitalization in the next decade or two.
Finally, if the experience of today’s emerging markets is
any indication, frontier markets could also benefit from a
jump in foreign direct investment. In 1990, emerging
markets received net inflows of under $2 billion; in 2009,
that figure was over $18 billion. Net inflows to frontier
markets in 2009 were slightly higher than the $2 billion that
today’s emerging markets saw in 1990. Thus, there could
be ample upside for net investment flows into frontier5
market countries.
20
2015
2020
2025
2030
2035
2040
Sources: Census Bureau, SEI
Advanced composed of top five country allocations of MSCI World Index
as of June 30, 2014 (Canada, France, Japan, UK and US). BRICS
comprised of Brazil, Russia, India, China and South Africa.
The population pyramids in the following three exhibits
(showing data as of December 31, 2013) provide a visual
depiction of just how significant the “youth dividend” is in
frontier markets. In Exhibit 6, the population growth peak
associated with the baby boomers (cohorts born from 1946
to 1964), as well as the subsequent slowdown in birth
rates, is quite clear.
Exhibit 6: Age Structure in Five Advanced Countries
100+
90-99
80-89
An Impending Demographic Dividend
70-79
60-69
Demographics are one of today’s most pressing concerns
in many developed markets. Slower population growth and
increasing longevity are raising the median age in many
advanced countries. As the median age of a population
increases beyond working age, it can undermine economic
growth, place strains on entitlement and other social
programs, and possibly undermine financial market
returns. Many of the world’s emerging markets will also
have to grapple with this dynamic in the coming decades.
However, most frontier markets are in a much more
favorable situation, as steady improvements in public
3
Marko Dimitrijevic, CFA, “A Case for Frontier Markets,” in Gordian
Gaeta (ed.), Opportunities in Emerging Markets, John Wiley & Sons
Singapore Pte. Ltd., 2013, pp. 177-178.
4
Ibid, pp. 192-193.
5
Ibid, pp. 188-189.
© 2014 SEI
50-59
40-49
30-39
20-29
10-19
0-9
0%
5%
10%
15%
Percentage of Total Population
Sources: Census Bureau, SEI
Combined populations of Canada, France, Japan, U.K. and U.S.
Exhibit 7 shows a similar but more recent dynamic
experienced in the combined populations of five key
emerging markets—Brazil, China, India, Russia and South
Africa—where growth rates leveled off and began to slow
about 20 years ago.
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3
Exhibit 7: Age Structure in BRICS
of institutional health give little cause for alarm. For
example, on corruption measures, our group of 17 fares
well compared to BRICS members, as shown in Exhibit 9.
While both still have a ways to go in order to close the gap
with developed markets, frontier markets also score
similarly to emerging markets on measures such as ease
of doing business.
100+
90-99
80-89
70-79
60-69
50-59
Exhibit 9: Corruption Slightly Better than BRICS
40-49
30-39
Frontier 17
5.0
20-29
10-19
BRICS
4.0
0-9
0%
5%
10%
15%
20%
3.0
Percentage of Total Population
Sources: Census Bureau, SEI
Combined populations of Brazil, China, India, Russia and South Africa
2.0
1.0
Exhibit 8 shows a radically different picture for the 17
frontier markets, where the overall birth rate has continued
to increase. Most demographers expect these population
dynamics to eventually follow a path similar to advanced
and emerging economies. But as these graphics show,
frontier-market population dynamics will be remarkably
different from the rest of the world in the decades ahead.
As long as they are accompanied by institutional
frameworks that foster constructive participation of these
large, youthful cohorts, the outlook for frontier-market
countries should be rather vibrant, especially against the
backdrop of a graying world.
Exhibit 8: Age Structure in the Frontier 17
0.0
2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
Sources: Transparency International, SEI
Index scores range from 0 (highly corrupt) to 10 (no corruption). Vietnam
was not included in 2007 and 2008 studies.
Inflation figures provide another check on institutional wellbeing, as low and stable inflation tends to be a reflection of
an independent and capable central bank. Aside from
heightened inflation pressures in 2008, inflation trends in
frontier markets have been favorable, as shown in Exhibit
10. Inflation has been falling overall, and the difference
between frontier and developed inflation rates has been
narrowing.
100+
Exhibit 10: Favorable Inflation Trends
90-99
80-89
12
70-79
Frontier 17
Advanced economies
10
60-69
8
Percent
50-59
40-49
30-39
20-29
6
4
2
10-19
0
0-9
0%
5%
10%
15%
20%
25%
Percentage of Total Population
Sources: Census Bureau, SEI
Combined populations of the 17 frontier-market countries listed on p.1.
Sources: IMF, SEI
Average annual rates of consumer price inflation; 1996-2005 excludes
Lithuania; * IMF forecast as of April 2014.
Institutional Deepening
The importance of solid institutions to the future of frontier
markets—education, healthcare, and legal and political
systems, for example—cannot be overstated. This is
another area that tends to vary quite a bit by country. But
for frontier markets as a whole, some common measures
© 2014 SEI
It should be noted that, among individual frontier-market
countries, there tends to be quite a bit of divergence on
these and other institutional measures. Thus, these areas
might also provide opportunities for active investment
managers to add value.
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Other Factors—Technology and Natural Resources
Frontier markets offer some other interesting features. One
of the most powerful is the rapid and widespread adoption
of communication and information technologies in recent
decades. By some measures, frontier and emerging
markets have closed the gap with high-income countries;
an example of this is shown in Exhibit 11. This dynamic
has the potential to confer many benefits, including
productivity growth (which supports rising incomes) and
the aforementioned institutional deepening. Exhibit 11 also
reflects the fact that some frontier markets are already
fairly well developed, and should thus be attractive
destinations for long-term investment capital as their
financial markets continue to evolve.
Exhibit 11: Technological Convergence
140
Mobile Phone Subscribers per 100 People
120
100
80
60
40
20
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
0
Frontier 17
BRICS
High income
Sources: World Bank, SEI
Natural resource endowments are another feature of many
frontier markets. These endowments have the potential to
confer a natural advantage in commodity exporting which
can be used to support social and economic development.
With Potential Promise Comes Potential Peril
When assessing any investment opportunity, one must
carefully account for risks. Fortunately, unlike John F.
Kennedy’s new frontier, the opportunities and perils of
frontier investing are fairly clear: frontier-market investors
must be cognizant of technical risks such as illiquidity,
inflation,
currency
fluctuations,
volatility
and
implementation shortfall.
Illiquidity and inflation risks should be monitored closely;
fortunately, the diversity of frontier markets should help
make it possible to manage these risks in a portfolio. And
although exchange-rate volatility is always a concern in a
global investment strategy, frontier markets might seem to
pose an additional degree of risk, due to financial
vulnerabilities associated with the smaller size of their
economies. Volatility is also a concern, as the shallower
financial markets in many frontier countries could prove to
be more vulnerable to sudden changes in investor
behavior and other shocks. However, over the 10-year
period ending June 30, 2014, the MSCI Frontier Markets
© 2014 SEI
Index actually exhibited significantly less monthly volatility
than the MSCI Emerging Markets Index, providing further
evidence of the diversity among, and low correlations
between, individual frontier markets. Of course, experience
shows that correlations between risky asset classes tend
to rise in periods of market stress, so investors in frontier
markets must carefully assess whether such an allocation
is prudent for their circumstances.
Investors must also be attentive to the risk of
implementation shortfall, or the inability to buy or sell
securities in the amounts or at the prices desired. The
same forces that give rise to the attractive market
inefficiencies mentioned earlier pose challenges to
implementing and managing a portfolio. Because frontier
markets are not yet a major asset class, liquidity tends to
be much scarcer than in developed and emerging markets
securities. As a result, trade management must rely on
good relationships with local brokers and other partners,
and portfolios will benefit from skilled and patient trading.
The higher transaction costs associated with frontier
markets reinforce the idea that this asset class is best
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suited to long-term investment horizons.
These
considerations further reinforce the case for professional
investment and risk management in frontier markets.
Finally, there are some non-financial risks to consider. For
example, some experts have argued that natural
resources are a curse. Others have claimed that a “youth
bulge” can increase the odds of social and political
upheaval. Historically, natural resource endowments have
been used to support economic development; they have
also been mismanaged or, in other cases, had little to no
impact. The association between commodity wealth and
economic development appears to depend heavily upon
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the institutional framework in any given country. As for
demographics, it has been argued that baby booms that
arise from the transition to lower birth and death rates can
lead to social upheaval as those large cohorts enter their
late teen and early adult years. (Some scholars have
argued that this dynamic was at work in the recent Arab
Spring, for example.) Like arguments over natural
resources, the youth-bulge theory is controversial and
unsettled. But the resilience of social and political
institutions in individual countries is something frontier
investors must also be attentive to. We believe an active
investment approach will be helpful in managing these and
other risks.
6
Benjamin Griffith, CFA and Clifford Quisenberry, CFA, “Exploring the
Early-Stage Frontier Markets: An Overview of the Most Neglected Equity
Markets,” Caravan Capital Management LLC. Accessed at
<http://efrontierjournal.files.wordpress.com/2012/02/exploring-the-earlystage-frontier-markets-final2.pdf>.
7
See, for example, Jeffrey A. Frankel, “The Natural Resource Curse: A
Survey,” NBER Working Paper 15836, March 2010. Accessed at
<http://www.nber.org/papers/w15836.pdf>.
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This material represents an assessment of the market environment at a specific point in time and is not intended to be a
forecast of future events, or a guarantee of future results. This information should not be relied upon by the reader as
research or investment advice. This information is for educational purposes only.
Information provided by SEI Investments Management Corporation, a wholly owned subsidiary of SEI Investments
Company. For those SEI Funds which employ the ‘manager of managers’ structure, SEI Investments Management
Corporation (SIMC) has ultimate responsibility for the investment performance of the Funds due to its responsibility to
oversee the sub-advisers and recommend their hiring, termination and replacement. SEI Investments Management
Corporation is the adviser to the SEI funds, which are distributed by SEI Investments Distribution Co (SIDCO).
There are risks involved with investing, including loss of principal. Current and future portfolio holdings are subject to risks
as well. Diversification may not protect against market risk. Diversification may not protect against market risk. There is no
assurance the goals of the strategies discussed will be met. Emerging markets involve heightened risks related to the
same factors as well as increased volatility and lower trading volume. Bonds and bond funds will decrease in value as
interest rates rise. High yield bonds involve greater risks of default or downgrade and are more volatile than investment
grade securities, due to the speculative nature of their investments.
Index returns are for illustrative purposes only and do not represent actual fund performance. Index performance returns
do not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest
directly in an index. Past performance does not guarantee future results.
For Financial Intermediary Use Only. Not for Public Distribution.
© 2014 SEI
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