In August, MSCI issued a consultation paper asking for opinions on the creation of frontier market indexes. With emerging markets correlating more closely with developed markets than ever before, investors are looking beyond them in the search for greater diversification. So it makes sense that index providers would want to create benchmarks for those markets. In addition to MSCI, FTSE is also reportedly working on developing its own frontier market indexes.

Investor Interest Grows

Constantine Papageorgiou, a vice president and portfolio manager at Acadian Asset Management, which provides global equity asset management and has a strong background in emerging markets, says that he has observed a general increase in interest in frontier markets just based on mentions in the media, questions from investors, and—most reliably—increases in the amount of inflows those markets are seeing.

"In the early days of emerging markets, one of the main drivers of investment in these markets was the diversification opportunity they provided. Fifteen years ago correlations between developed and emerging markets were actually quite low," Papageorgiou says. "As these emerging markets have matured, as they have received more and more foreign investor interest, the correlations between emerging and developed markets have increased over time. Although they do provide some diversification for portfolios, they're certainly not the great diversifiers they were 15 years ago or so."

Frontier markets, he says, exhibit much lower correlations to both emerging and developed markets, which makes them an attractive diversification opportunity. That and the growth opportunities presented by frontier markets are part of their appeal, according to Papageorgiou, but he adds that the fact that there have not been a lot of international investors operating in those markets can be another selling point. "It's entirely possible that there are certain anomalies or inefficiencies that may exist in the frontier markets that have been traded away in the developed or emerging markets over time," he says.

S&P Vice President of Index Management Alka Banerjee describes frontier markets as "insulated" from global economic shocks because they do not have huge amounts of global money flowing in and out of them according to global trends. Because of this insulation, they perform differently.

Challenging Frontiers

At the moment, of the major index providers, only S&P provides frontier market coverage. It acquired the IFC indexes and the Emerging Market Database (EMDB) used to calculate them from International Finance Corp., a member of World Bank Group, back in 2000. Frontier market indexes have been calculated using the EMDB since 1995. Currently, S&P defines 22 countries as frontier markets, a list that includes countries like Bangladesh, Croatia, Cote d'Ivoire, Latvia, Lebanon, and Ukraine. It will add Kazakhstan and Panama going forward from December 1.  

Most recently, in August, S&P launched the S&P/IFCG Extended Frontier 150 Index, which includes components from roughly 30 markets. Those markets include S&P's frontier markets but also some of its emerging markets that are excluded from the investable index series and some markets that have not yet qualified for the frontier markets indexes.

With S&P having a head start on frontier markets coverage of more than a decade, it does raise the question of why other index providers haven't gotten involved sooner. The answer is likely that other areas of the market seemed both easier and more lucrative to cover first. Frontier markets indexes are rather labor-intensive propositions, and it's only lately that they have started to get serious attention from investors. S&P, it should be noted, did not create its frontier markets index family from scratch, but purchased it.

Banerjee says that S&P knew frontier markets were not of much interest to investors in 2000 when it acquired the IFC indexes but believed that would change.

"In the last couple of years, interest has spiked considerably, and we are very excited to be in this space where we are literally the only provider with so much history and so much data," she says.

Banerjee says that although definitions can vary, frontier markets are usually much smaller than emerging markets, with much lower liquidity, and they may have as few as four or five stocks. A lack of information is the main challenge that an index provider faces in creating indexes for frontier markets, she adds, since the markets may be so small that they fall below the radar of data vendors.

"That's a key thing for us. We have to have very, very valid sources of information, either through a local data vendor, local brokerage house, local research house or the exchange itself, because none of the standard sources of information really work for these markets. You can't get information on corporate actions or market size or IPOs through Bloomberg or Reuters," Banerjee says.

Because of this issue, S&P did not launch its Vietnam index until it had an agreement in place that the Ho Chi Minh stock exchange would provide the company with data on a regular basis, she adds. Vietnam is one of the hottest frontier markets, and Papageorgiou says that some investors believe it will be the next China. FTSE, another possible entrant into the frontier markets indexing space, has already launched an index series for Vietnam, even though the country is not included in its regular index family.

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