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2017-11-30Macro `n Cheese

Frontier Markets, for index riders only?

In this week’s blog Roger goes meme-busting and advances a more systematic view of what “Frontier Markets” are, or at least should be.

My former employer was one of the first big users of Macrobond. And one characteristic of those early days was getting in-touch with Macrobond to get data added (to their credit, they did). Now, some 50-million time series later, a typical industry issue is, actually finding what you’re looking for amongst all that data. So, going forward at Macrobond, we will be taking a firm hold of this issue. If you have any bright ideas, feel free to contact me for a noncommittal discussion. Please add a note that your feedback is addressed to Roger. I cannot promise you as productive a discussion as you probably have with our support department, but I would sincerely appreciate the input.

Diving into data

Admittedly, this was a very complicated way of saying that today I will take a deeper look at the “Frontier Markets”1 (FM), for which data is hard to come by. My own prejudicial view of such markets has long been that they’re only interesting for people who like to gamble on political risks, hard to come by “convergence trades”, and/or are expecting an imminent advancement of a frontier market to emerging market status (and the subsequent reallocation flows sure to lift that particular market). As returns on investments and yields have dropped over the past decade or so, frontier markets have under many circumstances caught the eye of the investor community, despite being fraught with risks.

1The MSCI Frontier Market (FM) index consists of (as of June 2017): Argentina, Bahrain, Bangladesh, Croatia, Estonia, Jordan, Kazakhstan, Kenya, Kuwait, Lebanon, Lithuania, Mauritius, Morocco, Nigeria, Oman, Pakistan, Romania, Serbia, Slovenia, Sri Lanka, Tunisia, Vietnam, and the West African Economic and Monetary Union (WAEMU), which in practice is Senegal, Ivory Coast, and Burkina Faso (Benin, Guinea-Bissau, Mali, Niger and Togo are also part of the WAEMU but are not including in the MSCI FM index).

Neither nor

Macrobond Document
Chart 1: FMs, not exactly a success story

The above chart should at least cast some doubts on the superior returns argument of Frontier Markets that many FM fund managers utilize when selling their products. While that claim may be true for GDP-growth of individual frontier economies, I doubt it is true for the stock markets of each and every FM. And, if nothing else, it does indicate that we should be picky when choosing our FM fund managers (!). However, not only do FMs claim that fund managers get superior returns from FMs, but also that returns are uncorrelated to those of developed markets.

Macrobond Document
Chart 2: Correlation is high but lagged

While it seems safe to say that the return-correlation of Frontier Markets is lower than for EMEs, it is still very high. Furthermore, as with many other asset classes, correlation increases in times of stress. The only difference is what seems to be the lagged response of FMs, which is probably more an effect of the low liquidity and other inefficiencies in those types of markets. Indeed, this pattern is also visible in EMEs when the level of stress becomes sufficiently high. As such, neither EMEs nor FMs offer any real protection against general financial market stress.

Macrobond Document
Chart 3: In times of stress, we come together
Note: Both series have been correlated on MSCI developed markets index

Frontier Markets are an odd lot

Alright, by now it should stand clear that just piling up on any generic Frontier Markets fund (or ETF) might not provide us with the uncorrelated high Sharpe ratio performance we had hoped (note that we have not yet discussed political or other institutional risks), but does that mean that Frontier Markets are inherently poor investments?

Of course not. Not only does the possibility of advancement to EME-status offer some interesting investment opportunities2 but the pure economics of these economies – among other things, the “convergence trade” – should provide interesting opportunities to earn a decent return.

2For a recent study see here
Macrobond Document Macrobond Document
Chart 4a & 4b

So, what should we look for in a Frontier Market? Thankfully, growth and development economics comes to the rescue, and from what I can remember, it is a major mistake to take an overly simplistic approach looking at the success factor en vogue. Instead, and perhaps unfortunately, a more holistic approach is necessary – and to not only include concrete data such as capital investments and average number of years in school, but also institutional framework, gender equality etc. etc. This underlines our previous discussion that relying only on the “frontier market” status, for example, is utterly insufficient.

Now, there have been many attempts to capture all/most aspects of economic prospects in a single measure but of those I have looked at, I think I prefer Citi’s “3G index” (Global Growth Generators).

In short, this index reflects six success factors:

  1. The level of domestic savings and investments;
  2. demographic developments;
  3. health prospects;
  4. educational attainment;
  5. the quality of institutions and policies, and;
  6. the degree of openness.

However, considering recent research one might prefer to change the weighting schemes and/or perhaps include some other variables (climate change, inequality, financial sector, IT etc.). For those interested, the document is downloadable for editing in the MB-application.

Macrobond Document Macrobond Document
Macrobond Document Macrobond Document
Chart 5a-d: Choose your Frontier Markets wisely
Note: The series are standardized and added together with a quite arbitrary weighting scheme. Since some of the series demonstrate a slight trend, the levels of the 3G-index must be interpreted with caution and should perhaps (as Citi does) only be denoted index instead of standard deviations. Some alterations to the original 3G-index are made to try to filter out cyclical movements and for consistency.

As the charts above clearly demonstrate, there are broad discrepancies between different Frontier Markets. What we should look for are countries with low income levels compared to the global tech/econ leader (US), implying very strong convergence potential. However, to be able to harness this growth potential the countries need also score high in our “3G-ranking”. Thus, the rather non-informative “Frontier Markets”-meme, encompass countries from Bangladesh, with a mere 6% of US income levels, but who scores very well in our 3G-index (0.81), to Kuwait, with a whopping 141% of US income levels, but with a very modest result in our 3G-index (0.12). In general terms, it seems as if Asia is indeed home to most countries with strong future growth prospects, but countries like Romania, Morocco and Nigeria also seem to offer interesting opportunities.

You go first!

OK, so what have we learned? Well, first of all let us stop relying on cool acronyms and memes when searching for new investment opportunities (and themes)3. In general, and contrary to how the marketing slogans run, FMs neither offer better nor uncorrelated returns. Frontier Markets are (like EMEs) a very diverse set of countries that must be individually judged. In doing so, we must also take into account a number of diverse factors, both hard (like convergence potential) and soft (like inequality). Using such an approach we can nonetheless create simple indicators to help us scan Frontier Markets (and others). In this article, we used an improved version of Citi’s 3G index, but further improvements are of course possible. When investing in countries with low absolute income levels, scant academic evidence suggests that superior returns are possible with a more systematic investment approach like the 3G-index. …So, what are we waiting for? (U-hum, but you go first!)

3 The “reclassification premium” discussed above, nonetheless, contradict this.


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Disclaimer

We don’t usually have views and opinions about economic and financial states of affairs, (not ones that we express publicly as a company, anyway). We do believe, however, that people can and do appreciate a variety of perspectives. What you’ve just read is the perspective of our resident chief economist. While we think he’s very smart, Macrobond Financial does not expressly endorse the views he presents here. And, as the old adage goes, you shouldn’t believe everything you read (not without finding the data, performing a few analyses and presenting it in a nice chart). We want to make it clear that we are not offering this information as investment advice. That being said, if you have the application you can easily check everything that’s mentioned here, and decide for yourself. If you don’t have the application, now you have a great reason to get it.