MSCI Considers A New Frontier

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.

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.

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.

MSCI's proposal says that all countries that it does not currently cover would be considered for inclusion in its frontier markets indexes as long as they have a total market capitalization of more than $1 billion and "relative market openness." However, those countries also must have a market that could be the basis for an investable index. MSCI suggests halving its minimum size requirements for companies in its emerging markets indexes to full market capitalization of $93 million and float-adjusted market capitalization of $47 million. The minimum annualized traded value ratio (ATVR) required would be just 2.5% versus 15% for emerging markets. There also must be at least three viable index constituents. And finally, the country must be free of "extreme economic and political strife," which is no small thing. The questions that these requirements raise include how MSCI defines market openness and things like political strife.

From the list of countries meeting these criteria, 12 would be selected for inclusion in MSCI's frontier market indexes. The frontier market family would also comprise countries already covered by the MSCI indexes. Sri Lanka and Venezuela would be included as well as five of the six countries in MSCI's Gulf Cooperation Council index family: Bahrain, Oman, Qatar, United Arab Emirates and Kuwait. Saudi Arabia, the sixth country in the GCC index family, would be excluded because its market is not considered open enough. The end total would be a frontier market index family of 19 countries. Frontier markets would graduate to the MSCI emerging markets indexes if they meet MSCI's requirements for size and investability, do not place undue restrictions on foreign investors and have a stable and reliable operational framework, according to the consultation paper.

In an initial review, MSCI proposed a list of countries that included the likes of Bulgaria, Kenya, Romania, Kazakhstan and Vietnam. The lineup is somewhat different from that of the S&P index family. There are only seven countries for which the two frontier market index families would overlap, a fact that highlights the extreme diversity of the countries falling under the frontier designation and the wide variety of ways that those markets could be measured. However, another eight of the countries suggested for inclusion in the proposed MSCI indexes are also included in S&P's broad emerging markets index, the S&P/IFC Global Composite Index, but not in the S&P/IFC Investable Composite. Cyprus and Estonia are not in the S&P index family but are included in the proposed MSCI indexes. A significantly different list of component countries would likely be a positive way for MSCI to differentiate its indexes from the S&P IFC indexes, which have had more than 10 years to entrench themselves in the marketplace and the minds of investors.

MSCI raises several issues in its consultation paper and asks a lot of questions. Essentially, nothing about the proposed frontier markets indexes seems written in stone. The consultation paper asks what kind of role gross national income (GNI) should play in the selection process. High GNI per capita is associated with higher levels of economic development, and MSCI asks if only countries with higher or lower GNI per capita should be included in the indexes. The consultation paper also asks if a regional perspective is preferable to a single-country perspective and what regions are of greatest interest to investors. It raises another interesting issue when it asks if there would be problems for investors if the composite frontier markets index included large stocks from countries considered too small to have their own country indexes. With regard to tradable narrow indexes, such as a Top 25 index, the consultation paper asks what the typical characteristics and requirements should be and if country concentration is an issue of concern.

Another topic up for debate is whether small-cap stocks should be included in the frontier market indexes and if such coverage is necessary. Adding small-caps would increase the proposed number of components from 132 to 374, and would increase the index's market capitalization from $144 billion to $181 billion. Coverage of the market would jump from 79% to 98%.

The desired end result suggested by the consultation paper is a frontier markets index family that finds an optimum balance between investability and completeness of coverage, serves as a useful benchmark for long-term investors, and is fully compatible with the methodology of the MSCI Global Investable Market Indices.

Although S&P is firmly positioned as the leader in this area if only by virtue of the fact that it is the only major index provider currently in the frontier markets space, increasing investor awareness and interest means there is an opportunity for index providers looking to expand their coverage. MSCI has clearly taken several steps down the path to creating its own set of indexes, and it looks like it will probably be the next index provider to enter the space. What will be interesting to watch in the next few years is the debate that will inevitably arise over whether indexing makes sense in frontier markets, the way increased investor interest will affect the performance and correlations of the hottest frontier markets, and the inevitable investable products that will no doubt sprout in the marketplace once investor enthusiasm hits a certain critical point.

*Included in S&P's emerging markets indexes.
(1)Will be added to the S&P frontier markets indexes as of December 1.