Investors who have benefited from the boom in emerging markets over recent years are now on the look-out for the next source of growth, which is putting the spotlight on frontier markets. Frontier markets are often seen as ‘emerging’ emerging markets and they represent potential economic powerhouses of the future.
Today, frontier countries account for 22% of the world’s population, 6% of its nominal GDP, yet only represent 3% of world market capitalisation1. This proportion is set to rise as these markets develop, and could present investors with an exciting opportunity with potentially low correlation to developed market equities and to broader global emerging markets. Frontier markets investing is a logical next step for investors who have an allocation to emerging markets and are looking to expand it. However, the risks of investing in emerging market countries are magnified in frontier market
What are frontier markets?
Although there is no strict definition of frontier markets, they are usually seen as the next generation of emerging markets. Frontier markets can be characterized as those countries that are enjoying high economic growth rates but have made limited progress to date in developing liquid capital markets. They are generally either not represented in mainstream emerging market indices or today only have a very small weighting in them.
HSBC considers the countries in the chart below to be frontier markets. The list includes some ‘cross-over’ markets that feature in broader emerging market indices but display some of the characteristics of frontier markets.
The universe presented demonstrates that frontier markets are a very diverse group, and this feature is one of their attractions for investors. When we describe this universe as diverse we mean that individual countries generally do not correlate highly with each other, and that as an asset class they typically have relatively low correlation with other equity asset classes. However, even given this diversity, these markets do have some structurally attractive characteristics in common:
This robust economic growth is structurally driven by access to capital and technology from the developed world, favorable demographics and a large population base. Given that many of these countries have abundant natural resources, they have also benefited from the high commodity prices of recent years. The frontier markets opportunity is often compared to that of emerging markets 20 years ago, but in fact the frontier markets of today are generally in much better economic shape than their equivalents were 20 years ago. Over recent years, inflation has largely been brought under control in many frontier markets, and given several years of strong growth, many current account deficits have been turned into surpluses. This has created more robust platforms for future growth and which in some cases has been reflected in improving credit ratings.
As frontier market economies have improved, they have started to open up to foreign investors. Government debt markets are growing, and many frontier markets now support well-functioning stock markets (although they
remain small in terms of total capitalization).
According to the World Bank, the 2009 median stockmarket capitalization of frontier markets was just under 20% of GDP; the figures for emerging and developed markets were above 40% and 50%, respectively, so on a relative basis, there is plenty of scope for stock markets to develop.
Young, growing populations
Frontier markets encompass a population base of 1.2 billion people, and these populations are characterized by being much younger and faster growing than in developed or even mainstream emerging markets. By way of illustration, across frontier markets the median age of the population is only 30.2 years, compared with 40.5 years in developed markets1.
Nigeria and the demographic dividend
With a population estimated to be 160 million2 in 2011, Nigeria is by far the most populous country in Africa, and the eighth most populous country in the world. It is also one of the youngest countries in the world, as over 60% of the population is under 25, and the median age is 19. Nigeria is benefiting from the so-called ‘demographic dividend’ as the rising proportion of working age people helps to drive economic expansion, the growth of the middle class and the consumption of products and services.
Rising middle classes
The economic growth of recent decades has lifted millions of people out of poverty and created a new and aspirational group of consumers. Although much of the workforce in frontier markets is still employed in producing goods for international consumers, future economic growth will likely be fuelled by these domestic consumers. Goldman Sachs3 estimates that around two billion people globally will have joined the middle class by 2030, and many of these will be in frontier markets.
Infrastructure build-out opportunities
Many frontier markets are still in the process of developing and improving their infrastructure, to support their growing populations, and this creates many opportunities for domestic and foreign investment, which vary greatly from one market to another.
Post war reconstruction in Sri Lanka
Since the 25-year long civil war ended in 2009, the Sri Lankan government has embarked on a US$6 billion program to upgrade and reconstruct infrastructure across the country. There is a 10-year development program in place, which will concentrate on mainstream infrastructure such as roads, ports, bridges, rail, aviation, energy and irrigation, together with agriculture and tourism. This far reaching plan will provide many opportunities for private investment and has also led to the opening up of the financial system. Sri Lanka enjoyed GDP growth of 8.2% in 2011, with infrastructure development a main growth driver.
Qatar and the 2022 World Cup
Qatar successfully bid to host the 2022 World Cup, as part of its long-term strategy to diversify its economy away from oil and gas. Its ambitious plans to host the event include the construction of nine new stadiums and the renovation of three existing ones, 70,000 new hotel rooms, a rail and metro network and a bridge to Bahrain. Official estimates put the total cost at US$60 billion (around half of the 2010 GDP total).
Production and export of commodities
Many frontier markets have abundant natural resources and have benefited from the rise in commodity prices over recent years, fuelled by demand from emerging markets including China and India. This secular rise in commodity prices has led to increased government spending, infrastructure investment and higher standards of living for entire populations. Despite benefiting from the long-term trend in commodity prices, many frontier stock markets are somewhat insulated from short-term commodity price movements, as commodity-producing companies (in particular oil) tend to be government owned or part of global multinationals, and so are typically not listed on stock exchanges.
Kazakhstan has a very rich resource base, which encompasses oil and gas fields and a large variety of mineral reserves including chromite, lead, zinc, uranium, copper, gold and iron ore. Kazakhstan is estimated to have nearly 40 billion barrels of oil reserves in the Caspian Sea region, putting it ninth in the world. Its Tengiz oil field is one of the largest in the world, and the Kashagan oil field was one of the most significant finds of recent years. Kazakhstan is also the world’s largest producer of uranium, responsible for over 30% of global output.
Mongolia's vast reserves of high-quality coal, combined with its close proximity to China, the world's largest consumer of coal, as well as Russia, make Mongolia a growing strategic player in the global coal market. The country is estimated to have potential coal reserves of 100 billion metric tons, most of which are yet to be developed. China obtains approximately 70% of its energy needs from coal, and its closeness to Mongolia means that it is increasingly reliant on the country’s exports. The Mongolian government also plans to extend the railway system to serve markets further afield.
Frontier markets as a diversifier
Another benefit clients may capture through an allocation to frontier markets is diversification. Diversification does not protect you against a loss in a particular market; however it allows you to spread that risk across various asset classes and/or countries. Furthermore, asset allocation does not guarantee a profit nor protect you from a loss. Historically, frontier markets have been among the least correlated to other equity classes globally, making them attractive from an asset allocation point of view. As the chart below shows, frontier equities have exhibited much lower correlations with global equities than mainstream emerging markets have, even during the 2008 crisis when correlations across all types of equities rose sharply. They are also lowly correlated with commodity indices.
In addition, frontier markets offer an additional layer of diversification, because they often have low correlations with each other. This is a product of their diversity, as they are driven by many different and often localized factors, and also frequently operate in different currencies. As a result of this, frontier markets have historically been less volatile than mainstream emerging markets, as the next chart demonstrates.
Risks of investing in frontier markets
As is the case for all investments, frontier market equities are not without risk, and we outline some of their specific challenges below. Many of these risks are functions of the immature nature of the asset class, and also represent opportunities for long-term investors. These risks may also be mitigated by creating a well diversified portfolio.
Although many of these countries are much more stable than was the case a decade ago, there is definitely still an element of political risk, as the events of Arab Spring have illustrated. Aside from geopolitical events, which can disrupt investment or cause markets to close, there is also the possibility that restrictions or financial penalties can be imposed on foreign investors without warning. Liquidity constraints Frontier stock markets are still in the process of developing, and so are sometimes thinly traded, which can present liquidity risks which need to be carefully managed. As the markets mature, liquidity should improve.
Many frontier market currencies are undervalued on a purchasing power parity basis and so are expected to appreciate over the long term, which could provide a potential additional source of return. In order to benefit from this potential appreciation over the long-term, investors may have to ride out potential volatility in the short to medium term.ferent and often localized factors, and also frequently operate in different currencies. As a result of this, frontier markets have historically been less volatile than mainstream emerging markets, as the next chart demonstrates.
The investment universe
At HSBC, our frontier markets investment universe includes countries that are in the MSCI Frontier Markets index, as well as emerging markets which are considered ‘cross-over’ markets, and a number of companies that are listed outside frontier markets but are heavily exposed to them. ‘Cross-over’ markets are those that are formally included in main emerging markets indices but exhibit some “frontier markets” characteristics, such as foreign investment restrictions, lower correlation with global markets and/or other economic and political factors. Examples of our ‘crossover’ markets include Philippines, Egypt, Morocco, Peru and Colombia.
While the majority of index providers produce frontier market indices, there are significant differences between them with respect to country and regional representation, and we believe that none of them really give a true representation of the frontier markets universe. The MSCI Frontier Markets index, for example, is very heavily weighted in Middle Eastern countries, while other regions are under-represented. At HSBC we have carried out extensive studies of the underlying markets, and have worked with MSCI to design an MSCI Capped index which we believe more accurately reflects the frontier markets opportunity and provides sufficient diversification to have a well-balanced universe. This index is based on the MSCI Frontier Emerging Markets index but caps the weight of the combined ‘cross-over’ markets and also caps any individual country weight at 10%, and so solves the issue of too much concentration in any one region or country. A comparison of the makeup of existing indices and our capped index is shown below:
How to access this strategic opportunity
Frontier markets present an interesting long-term investment opportunity, as they offer above average growth potential through economic cycles, together with potentially lower than average volatility.
We believe the best way to access this opportunity is through a strategic allocation to frontier market equities. Although some general emerging market managers have the discretion to invest in frontier market equities as part of an emerging market mandate, this may not harness their full potential e.g. if investment is limited only to the most liquid frontier market stocks or if the smaller frontier countries are overlooked. These markets are typically less researched and less liquid than most equity markets, and so tend to be less efficient.
The resulting pricing anomalies can create exciting ‘alpha’ opportunities, which generally can more systematically be captured by active managers who have the commitment, skill, and global resources available to do the necessary research and take advantage of such market inefficiencies.
The risks to investing in these markets have been outlined within this paper, but many of them may be mitigated by the construction of a well-diversified portfolio, with a broad spread of countries, currencies and sectors.
Investors seeking sources of long-term growth with low volatility can consider a potential allocation to frontier markets as a complement to their existing global emerging markets exposure.
1 IMF World economic outlook database - October 2009.
2 IMF World economic outlook database - April 2012.
3 Dominic Wilson and Raluca Dragusanu, “The Expanding Middle: The Exploding World Middle Class and Falling Global Inequality,” Goldman Sachs Global Economics Paper No. 170 (2008).
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Where overseas investments are held the rate of currency exchange may cause the value of such investments to go down as well as
up. Investments in Frontier Markets are by their nature higher risk and potentially more volatile than those inherent in established
markets. Economies in Frontier Markets generally are heavily dependent upon international trade and, accordingly, have been and
may continue to be affected adversely by trade barriers, exchange controls, managed adjustments in relative currency values and
other protectionist measures imposed or negotiated by the countries with which they trade. These economies also have been and may
continue to be affected adversely by economic conditions in the countries in which they trade. Investors should note that changes in
the political climate in Frontier Markets may result in significant shifts in the attitude to the taxation of foreign investors. Such changes
may result in changes to legislation, the interpretation of legislation, or the granting of foreign investors the benefit of tax exemptions or
international tax treaties. The effect of such changes can be retrospective and can (if they occur) have an adverse impact on
investment returns. Stock market investments should be viewed as a medium to long term investment and should be held for at least
The MSCI Frontier Markets Index is the main frontier index, restricted by high concentration and narrow geographical coverage. Over
60% of the index is represented by the Middle East, including more than 30% to Kuwait alone
The MSCI Frontier Emerging Markets (uncapped) Index includes all the countries in the MSCI Frontier Markets index and also
includes 5 'small' countries from the MSCI Emerging Markets index (these are what we call 'cross-over' markets): Colombia, Peru,
Egypt, Morocco, Philippines. It is a broader index than (1) as it includes more countries but it still has concentration in certain big
The MSCI Frontier Emerging Markets (capped) Index is a capped version of the uncapped index, The capping mechanism is two fold:
1) There is an initial cap of 25% for the combined weight of the 5 crossover countries. This gets reset back to 25% if it breaches 30%.
2) There is an initial cap of 10% for any other country. This gets reset back to 10% every time it breaches 12%. The capped index is
maintained and calculated by MSCI.
The indices do not include any expenses, fees or sales charges, which would lower performance. The indices are unmanaged and not
representative of any HSBC investment. It is not possible to invest directly in an index.
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