View From The Frontier
By Amy Schioldager, Jerry Moskowitz, Kurt Zyla, Richard Kang, John H. Christy III, Bruce Bond, Alka Banerjee

The traditional argument holds that these higher-risk markets also offer the opportunity for higher, more growth-oriented returns, and perhaps more importantly, for returns that are uncorrelated to the rest of the market. In other words, diversification is the name of the game. But is that all there is to the story?

Heather Bell, assistant editor for IndexUniverse.com and Journal of Indexes, spoke with leading experts in the space to explore what frontier markets are, what challenges they present and how they might fit in investors' portfolios.

Amy Schioldager, managing director and head of indexing, Barclays Global Investors

Journal of Indexes (JoI): What distinguishes a frontier market from an emerging market?

Amy Schioldager, Barclays Global Investors (Schioldager): I think the tough thing is it's hard to use any single metric, like GDP. There is no single metric that I would point to; I think it's more the overall stage of development of the market itself, although you're always going to have some countries that are on the border of whether or not they're really emerging or really frontier, like Jordan and Colombia.

JoI: Do frontier markets provide a new level of noncorrelated returns?

Schioldager: Absolutely. We have a frontier markets fund, and we have talked to many clients about frontier markets: The biggest attraction is the diversification afforded by adding frontier markets.

When you look at equity markets these days, typically you see correlations at 0.85 and above, but the correlation of frontier markets to the S&P 500, for instance, is a very low 0.25. When we look at emerging markets, which is where you'd expect frontier markets to have a higher correlation, it's still very low at 0.4. I think that's really one of the driving factors for why an investor would want to think about adding frontier markets to their allocation.

JoI: Should investors be worried about liquidity and concentration issues in frontier markets?

Schioldager: When you buy a diversified range of frontier markets, that individual company concentration that can occur when investing in a single market doesn't exist. I think it's very hard to go out and buy individual countries in frontier markets, and that's not what I would recommend. If you have a diversified basket of stocks across a geographical fleet of countries, then you don't have to worry about the concentration because you have diversification. And when you put those frontier markets all together, you end up with nicely diversified sector exposure that is quite similar to an emerging market basket.

With regard to liquidity, these markets are less liquid than emerging markets that are less liquid than developed markets that are less liquid than the U.S. My recommendation to an investor is to work with somebody who understands the importance of trading over time and managing the cash flows into these markets to ensure that you're not impacting the marketplace by putting too much money in them.

JoI: How risky are frontier markets relative to emerging and developed markets and to other equity classes?

Schioldager: You'd be surprised. We measure risk in terms of absolute volatility. What we see is that the U.S. and EAFE have volatility numbers of roughly 14 percent, so those are right in line with each other. Emerging markets have a volatility of roughly 20 percent. But what's interesting about frontier markets is their volatility is about 13 percent—that is, for a diversified basket of frontier market countries. It's lower than both EAFE and the U.S., as well as emerging markets.

These markets are not globally integrated. They're very much focused on their own domestic demand in large part, and with the lack of global integration, they don't have high correlations with each other. When we look at the 16 markets and compare correlations one by one with each other, what we see is that none of them is over 0.5, and most of them are under 0.3. When you combine a basket of low-correlating markets, you lower the overall volatility. The average country volatility for these markets is about 26 percent, so that's more in line with what you would expect, given that the number for emerging markets is about 20 percent. When you combine them, because of the low correlations, you end up with a basket of countries with a lower volatility relative to the U.S.

JoI: Is indexing an appropriate approach to frontier markets?

Schioldager: I would say yes. Soundly yes, loudly yes. I believe so because of the diversification issue. I think that if you try to buy a single country, you may end up heavily concentrated in one sector. I think if you try to pick and choose either countries or stocks within a country, you're not going to get the low-correlation and diversification story. You could end up with something that could be highly concentrated and skewed toward specific sectors.

I think the beauty of indexing is that it provides a diversified basket of stocks not only across geographic locations and countries, but also across sectors.

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