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The Lure of the Frontier

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Here’s an emerging market with some impressive numbers: Argentina’s stocks had an inflation-adjusted average annual return of 10.9 percent in a decade when equities in the United States averaged 7.1 percent and, in the United Kingdom, a mere 1.8 percent. And the following decade, Argentina continued to outperform, with a 4.5 percent annual gain, while U.S. and U.K. stocks dropped annually by 2.5 percent and 1.4 percent, respectively.

Chances are, though, that your clients didn’t benefit from these differentials. The two decades in question were 1900-1910 and 1910-1920 (calculated from January 1 to January 1 and compiled in the 2003 book A New Economic History of Argentina).

“Emerging markets” have been a major focus of the investment industry’s attention for the past two decades, and more recently, that attention has been supplemented by a growing interest in “frontier markets.” The latter term is taken to mean markets that are less well-developed than traditional emerging markets, in terms of size, liquidity and accessibility.

Back in 1952, French sociologist Alfred Sauvy coined the term “third world” for those countries that were not part of the developed “first world” or the Communist “second world.” In the early 1980s, Antoine van Agtmael, a Dutch banker then at the International Finance Corporation, began touting “emerging markets,” after finding that investors balked at the “third world” label. (It didn’t help that his proposed Third World Equity Fund came to be known as Third World Investment Trust — or TWIT.)

The term “frontier markets” is generally regarded as having originated in the mid-1990s when Standard & Poor’s began using it as a label in its index calculations. It’s become more widely used than alternatives such as “pioneer markets” and the unwieldy “emerging emerging markets.”

The categories of emerging markets and frontier markets have some fuzziness around the edges. Where exactly the boundary lies between frontier and emerging depends on the precise definitions used, as do questions of when a market is no longer emerging but rather developed, and whether frontier status itself requires meeting a certain threshold of openness to foreign investors.

Geographically, this frontier tends to be found in Eastern Europe, South Asia, the Middle East and sub-Saharan Africa. Nations widely regarded as frontier markets include Romania, Bulgaria, Sri Lanka, Vietnam, Kenya, Nigeria, Bahrain and Qatar. Lately, new indexes have been developed to monitor frontier markets, and exchange-traded funds have begun specializing in the new asset class. (See sidebar, “Tracking the Frontier.”)

Repeating the Past?

A great deal of interest in frontier markets has been driven by expectations that they will replicate the largely upward trajectory of many emerging markets over the past two decades. Coupled with such hopes are concerns that as traditional emerging markets move toward or into the developed category, they will no longer have the growth prospects of yore.

Enthusiasm for frontier markets also owes much to the broad surge in commodity prices of recent years, as many frontier-market countries derive a significant portion of their revenues from commodity exports. That raises the question of whether the frontier might become notably less attractive in an environment of weaker commodity prices.

Moreover, emerging markets with strong performance have often benefited from economic reform and not just upswings in commodity prices. A broad trend toward economic reform existed, however unevenly, in emerging markets over the past two decades. Worryingly, such a reformist trend is harder to discern in frontier markets today. Then again, some frontier markets, notably Persian Gulf oil exporters, have amassed much greater wealth per capita than was the norm among emerging markets in the past, and thus may be relatively well-positioned for their small equity markets to develop.

Investor interest in emerging markets in the early 1990s owed a great deal to the introduction of Brady Bonds, named after Treasury Secretary Nicholas Brady of the George H.W. Bush administration. These instruments enabled a number of nations, particularly in Latin America, to restructure their foreign debt and gain credibility as plausible environments for equity as well as fixed-income investment.

The mid- to late 1990s saw renewed turbulence in emerging markets, with Mexico’s peso crisis of 1994, Thailand’s 1997 devaluation of the baht and Brazil’s 1999 retreat from the dollar peg of its currency, the real. However, by early in the current decade, investor confidence in emerging markets was on the upswing again, strengthened by reformist policies such as Brazil’s embrace of inflation targeting. The MSCI Emerging Markets Index, which peaked vis-?-vis the MSCI World Index in 1994 and then lagged behind it in the late 1990s, resumed beating the global benchmark handily in 2003.

Longer History

Much commentary on emerging and frontier markets could give the impression that the history of emerging markets goes back little more than 20 years, and that frontier markets have only recently entered existence. In fact, many markets now regarded as either emerging or frontier have a considerably longer history, dating back decades or even centuries.

Argentina’s main stock exchange, for instance, was founded in 1854, and trading expanded for decades as the country’s modernization proceeded apace. Argentina’s early-20th-century boom did not last, however. Populism, protectionism, military coups and inflation overshadowed the nation’s market from mid-century into the 1980s, making it a backwater from the perspective of international investors. It was only after inflation hit some 5,000 percent in 1989 that structural reforms began, including trade liberalization, privatization and monetary restraint, enabling Argentina to “emerge,” or rather re-emerge.

Similarly, frontier markets are not necessarily entirely new to the investment scene. Bulgaria and Romania both had stock markets in the early 20th century that ceased to exist with the imposition of Communism in the late 1940s. Bulgaria’s Sofia Stock Exchange, which became active in 1914, was turned into a department of the national bank and effectively shut down in 1947; the market reopened as the Bulgarian Stock Exchange half a century later. Romania’s Bucharest Exchange dates back to 1882 but was abolished by the Communist regime in the late 1940s. It resumed trading in 1995.

In Kenya, European colonists conducted an informal market in securities beginning in the 1920s, and the Nairobi Stock Exchange was set up in 1954, though it was initially limited to whites. After Kenya gained independence in 1963, trading activity slumped as a result of political uncertainty. In the mid-1990s, the Kenyan government began loosening restrictions on foreign capital flows, opening Kenya as an investment frontier.

The sweep of history, both recent and distant, gives cause for both optimism and pessimism about frontier markets today. It suggests that stock markets in developing countries can be crucial tools and measures of rapid increases in wealth. It also suggests that building successful stock markets is an arduous task, and one that requires a solid basis of sound economic policy and political stability.

Tracking the Frontier

New tools have proliferated for monitoring and tapping into frontier markets. Standard & Poor’s maintains several frontier indexes including the S&P Frontier Broad Market Index, or BMI, which tracks over 600 companies in 34 countries; the S&P/IFCG Extended Frontier 150, which follows 150 companies in 27 markets; and the S&P Select Frontier, which narrows the extended list down to 40 of its largest and most liquid stocks.

MSCI Barra’s Frontier Market Indices cover some 180 securities in 22 countries. These are combinable into regional composites such as the MSCI FM Africa Index and the MSCI Frontier Markets (FM) ex GCC Countries Index, which excludes Gulf Cooperation Council oil exporters.

The FTSE Frontier Index tracks 50 of the most liquid stocks from an eligible universe of 23 frontier markets. Countries with companies recently in the index include Bahrain, Bangladesh, Croatia, Cyprus, Estonia, Jordan, Kenya, Mauritius, Nigeria, Oman, Qatar, Romania, Slovenia and Vietnam. FTSE maintains a country classification system with four categories: developed, advanced emerging (which includes Brazil and Taiwan, for example), secondary emerging (such as Argentina and India) and frontier.

To qualify as a frontier market under FTSE’s system, a country must meet the following five criteria: a formal regulatory authority actively monitoring the market; no significant restrictions or penalties for capital repatriation; rare incidence of failed trades in the settlement process; a clearing system that takes not more than seven days; and adequate transparency. Markets that meet additional criteria, such as having well-developed brokerage and custodial services, move out of the frontier category.

Funds Go Forward

As frontier markets have become more subject to indexing, exchange-traded funds have edged into the nascent asset class. ETFs focused on frontier markets include Claymore/BNY Frontier Markets ETF (symbol FRN), PowerShares MENA Frontier Countries Portfolio (PMNA), the WisdomTree Middle East Dividend Fund (GULF) and Van Eck’s Market Vectors Africa Index ETF (AFK) and Market Vectors Gulf States Index ETF (MES). Morgan Stanley’s Frontier Emerging Markets Fund is a closed-end fund that trades under the symbol FFD.

Kenneth Silber is a senior editor at Research. His work on science, economics and history has appeared in a variety of publications, including The Wall Street Journal.


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