Frontier Markets In Focus

One could argue that 2008 was the year that investors discovered frontier markets, as ETF providers launched the first exchange-traded products to cover that designation. With none of those funds trading prior than last year, there is no annual data available, but the MSCI Frontier Markets Index fell 55.41% for the year, about the same as the MSCI Emerging Markets Index. The combined emerging and frontier markets index lost 54.44%.

Quarterly data is available on most of the frontier ETFs that launched, however. The S&P 500 was down 21.94% during the fourth quarter, when the worst of the credit crisis hit the markets. By comparison, the MSCI Emerging Markets Index was down 27.94% and the MSCI Frontier Markets Index was down 41.03%—frontier markets had held up relatively well throughout the year in comparison with standard emerging markets, but the fourth quarter revealed that their outperformance was simply the result of a delayed reaction.

Of the frontier funds, the broadly focused Claymore/BNY Mellon Frontier Markets ETF (NYSEArca: FRN) fell a little less than 30%. (Note, however, that FRN's largest component is Chile, which is generally considered an emerging market and represents more than a quarter of the portfolio.) Meanwhile, the Market Vectors Africa Index ETF (NYSEArca: AFK) was down about 35% during the quarter, and the Market Vectors GCC Index ETF (NYSEArca: MES), which covers the countries of the Gulf Cooperation Council in the Middle East, was down 39%.

What Happened To EM's Diversification Benefits?

One of the big questions lately has been whether this broad-based decline means that the concept of "decoupling" is now null and void. After all, frontier and emerging markets were hit even harder than developed markets.

The appeal of such markets has traditionally been based on their low correlation with the developed world and the diversification that provides for investors' portfolios. It's true that correlations among markets—especially between developed and emerging markets—have been increasing, but the diversification benefit has by no means disappeared.

The important thing to remember is that 2008 by no means represents an average year. The declines seen in global markets were broadly based, and it was the rare asset class that didn't take a severe hit.

"All asset classes basically converged to a correlation of one or pretty close to that. We saw the same thing happen with emerging markets, with commodities, with real estate, with infrastructure," said Amy Schioldager, managing director and head of indexing at Barclays Global Investors.

"There's no asset class that you can really point to and say that, in the last half of 2008, it was a diversifying asset class, because nothing was. Everything was reacting in the same manner and had negative returns," she added.

Alka Banerjee, Standard & Poor's vice president of global equities, believes some investors may not be seeing the full picture. 

"One thing that is very clear is that the global markets are very interlinked. There's no such thing as being completely out of the loop," she pointed out.

For example, Banerjee notes that emerging markets are dependent upon developed markets to buy their products. As a result, she notes that developing economies can be directly impacted by economic conditions in developed markets.

In fact, Banerjee says gross domestic product growth is where the real "decoupling" takes place. Even if an emerging market's GDP growth falls from 10% to 5%, it will still be higher than that of developed markets, she notes.

"That's more of a decoupling on a trend line," Banerjee said.

Like Banerjee, Schioldager believes that GDP is important to consider when discussing decoupling, noting that recent IMF projections for emerging markets for 2009 put GDP growth at 3%-4%, while GDP was expected to fall by 1% for developed markets. She says that the IMF has put five-year average GDP growth for emerging markets at 5.1%, but at just 1.9% for the U.S.

So what in particular pushed emerging and frontier markets off the cliff?

Those markets do not exist in a vacuum, point out indexing experts. They might be less linked to developed markets, but a more globalized world makes ripple effects much less avoidable.

"When I look at the first half of the year, there were a lot of inflation worries, the markets were pretty overheated, core inflation numbers had increased, commodity exporters were doing pretty well," Schioldager said of emerging markets.

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