Time to cross the frontier?

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Based on commonly accepted standards, world stock markets fall into two distinct groups: developed and emerging. There are 23 developed markets and about 30 emerging countries where stock markets are functional but not as mature or as stable as in developed nations. However, among more than 190 countries worldwide are the so-called ‘frontier' markets which we believe are in the same position occupied by emerging markets 15 years ago: following a path of economic expansion and modernisation of their financial infrastructure that could lead to sizeable opportunities for investors.

We would suggest that frontier markets investing is an attractive proposition given their risk-return characteristics and growth potential. It is true that company data quality is still far behind that of emerging markets although it is steadily improving. Analyst coverage of individual frontier stocks is sparse at best. Investors also face challenges in terms of portfolio construction, trading and settlement. Liquidity is very low by comparison with other markets, averaging approximately $40m (€30m) daily.


Frontier market valuations have risen this year, currently showing a trailing P/E ratio of 17.2 compared to 14.2 for emerging markets and 15.4 for MSCI EAFE. However, these countries are showing signs of strong economic momentum and growth prospects are good. Further, we view frontier markets as a long-term investment and timing the point of entry correctly should not be the over-riding objective.

The list of countries categorised as frontier includes Bulgaria, Croatia, Estonia, Latvia, Lithuania, Romania, Slovakia, Slovenia, and the Ukraine in Europe; Botswana, Cote d'Ivoire, Ghana, Kenya, Lebanon, Tunisia, Mauritius, and Namibia in the Middle East and Africa; Ecuador, Jamaica, and Trinidad and Tobago in Latin America and the Caribbean; and Bangladesh in Asia.

Major factors differentiating frontier markets from their emerging counterparts include a less
developed infrastructure and a weaker critical mass spurring economic development. For example, the population of frontier markets is about 409m compared to 3.948trn in emerging markets. Total GDP based on purchasing power parity is $1.5trn versus $22trn. The unemployment rate averages 15% compared to 10% while the current account balance is a negative 1.15% of GDP versus a positive 0.64%.

These differences are substantial and yet other characteristics display similarities between the groups. Literacy rates, life expectancy, corruption levels and even internet usage are just some examples. Economic growth potential is also an attribute common to both emerging and frontier countries.

Decades ago, investment pioneers promoted international diversification as a way to realise higher returns with lower risk. As global market correlations increase this is becoming harder to achieve. However, because frontier markets are less integrated with the rest of the world, the correlations between frontier and other markets are low, offering significant opportunities for diversification.

This is illustrated in the table which also shows that frontier correlations are much lower than those of emerging markets.

In December 1995, S&P introduced a global frontier composite index with monthly coverage. The index had an annualised return of 11.6% from December 1995 to December 2005 compared to 8.2% for the MSCI emerging markets index.Interestingly, the index volatility of 11.6% for frontier markets is also much lower than the 23.8% displayed by emerging markets; this is in part a result of the high autocorrelations in the frontier markets due to their low liquidity.

Our investability criteria for frontier markets embrace total market capitalisation, average daily trading volume, and the availability of timely prices and data. There are over 350 frontier stocks with a total capitalisation of around $110bn. The largest 25 stocks, capitalised at over $1bn, make up $60bn of the total. There are over 50 stocks capitalised at more than $500m.

Bloomberg provides sufficient information to monitor the daily trading volumes of many stocks in the frontier universe. The total average one-day liquidity of the 25 largest companies recently was approximately $14m. For the 50 largest companies, the total average daily liquidity was roughly $22m and the total for all frontier markets stocks was over $40m.

As these markets tend to have very low correlations among themselves with little risk of contagion, the need for immediate withdrawal from all markets at once in times of crisis should be low. Allowing 20-day trading volume with low turnover in a single strategy, this would produce passive investment capacity of approximately $800m with all stocks included.

For an active strategy, we can assume one third of the stocks are attractive, which produces a total capacity of $265m. Taking a more conservative approach to liquidity, by excluding stocks with a market cap of less than $500m, the active capacity is $148m. Assuming that trading takes place once a week to avoid overtaxing liquidity, a portfolio of such capacity could take nearly six months to become fully invested.

Our criteria also assume that stock exchanges are properly established with effective governance and trading mechanisms; that international brokers are present at the local exchange; and that established custody banks are acting on behalf of institutional investors to safeguard ownership and facilitate transactions. For many frontier markets these are major assumptions to make but, as with company data, standards are on a rising trend.


he lack of reliable historical data makes the development of country and stock models in frontier markets extremely difficult. We would also point out that country selection typically accounts for most of the potential investment gains in frontier markets, since sector differences are not as important in frontier markets as in developed markets and frontier stocks tend to move in a similar direction within their market.

Since we believe that frontier is a natural extension of emerging, we simply apply our emerging markets country model factors and factor weights where these factors are available in frontier countries. Except for forward-looking earnings growth data, all of our emerging markets factors are available for most frontier countries, including two value factors, an interest rate factor, a risk factor, a long-term mean reversion factor and an industrial structure factor.

Most stocks in frontier markets do not have analyst coverage and therefore lack forward-looking factors. Of the largest stocks mentioned previously, only seven have analyst coverage, with UKRNAFTA, a Ukraine energy stock, having the most, with four analysts. However, all the large stocks have current price-to-book and price-to-earnings ratios available, these being the most critical valuation variables. Most other stocks in the universe also have the basic valuation data.

Frontier markets have a short history and represent a novelty to most investors. In researching the investment potential of these markets, we recognise that accurate data can be hard to come by, liquidity is typically tight and trading and settlement often cumbersome. But the same was true of emerging markets 15 years ago and our experience shows that a commitment to those markets at an early stage has been more than amply rewarded.

While not ignoring risk, we believe the economic growth momentum of the ‘new emerging' markets bodes well for returns over the long-term. We also note that over-exposure to these markets is limited by the capacity constraints discussed earlier.

In conclusion, we would argue that a quantitative, model-driven approach, based on data that may be imperfect but is becoming ‘cleaner' by the day, works best.

Constantine Papageorgiou is vice president and portfolio manager at Acadian Asset Management, with offices in Boston and London

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