Forging Frontier Markets
Frontiers are very rarely stable. The very notion of a frontier appeals to our inherent desire to push ahead, explore and discover new opportunities. As it has always been with the physical boundaries conquered by explorers or the knowledge boundaries overcome by scientists and philosophers, so it is with investment markets.
Market frontiers are dynamic - constantly moving - as little-known opportunities in countries, technologies or industries are uncovered and evolve into established assets with measurable properties. In this case, the risk, return and correlated properties are central to the management of investment portfolios. If you're interested in breaking new ground in portfolio, read on to find out how frontier investments do just that.
The Dynamic Frontier Vs. the Static Investment Policy
Despite the dynamic environment of a frontier market, we often encounter a certain rigidity when studying the role of frontier markets in investment decisions. For example, investment policy statements will typically allocate weighting for non-domestic equities into a binary division of developed and emerging markets, as if there were no middle ground between, say, Germany and Egypt.
All countries that fall into a published category of "emerging" markets (for example the Morgan Stanley Capital International (MSCI) indexes) may make up some small, fixed percentage of a portfolio, while a mix of the world's so-called developed markets of North America, Western Europe and Japan will usually be awarded a higher weight to reflect the lower perceived risk.
This artificial construct, though arguably useful from a practical standpoint in its simplicity, does not accurately reflect the dynamic movement of markets along a continual spectrum of risk-return correlation opportunities. Investors who are aware of this dynamic frontier can benefit from more precise management of risk-return exposures. To start with, it can be helpful to have a historical perspective on frontier markets and how the frontier has evolved over time. (To learn more about the risk/return relationship, be sure to read the Risk/Return Tradeoff section of our Financial Concepts Tutorial.)
A Brief History of Frontier Markets
The Investment Landscape in the 19th Century
The middle of the 19th century was tumultuous, with major social and political change occurring in Europe while the Industrial Revolution, which had first emerged in late 18th century Britain, was disrupting and transforming economies from Liverpool to Leipzig. Across the
And the U.S. was not the only frontier market of its day - the English, Dutch, French and Spanish colonies in Southeast Asia, the Middle East, Africa and Latin America were all at various times attractive investment draws for wealthy European families and institutions. Unlike these markets, though, the
The term "emerging markets" - at least insofar as it relates to investment portfolio management - really didn't come into vogue until the 1980s, yet there was an earlier prototype.
A Succession of Tigers
The success of the Japanese export model launched the next wave of frontier markets - the so-called four Asian Tigers of
The dynamic frontier pushed out further still as other Asian economies like
Globalization and Frontier Markets
As countries evolve along the dynamic frontier, their importance to the global economy tends to increase commensurately. Four countries that appeared on the frontier at different points in time during the 1980s and 1990s - Brazil, Russia, India and China (popularly known by the acronym "BRIC") - accounted for more than 20% of global GDP (on a purchasing power parity basis) by 2007. By 2005, more than 40 countries could boast a stock market capitalization in excess of $100 billion.
All of these measures attest to the power of globalization in reshaping the international investing frontier. Indeed, the breadth and depth of global investable markets has been a benefit to investors seeking more opportunities for effective risk-return positioning. Figure 1 shows a selection of such markets, all of which have emerged on and evolved along the dynamic frontier over time. It also shows a variety of risk-return positions. (Learn what both the supporters and the critics have to say about this growing global trend, in our related article The Globalization Debate.)
 |
| Figure 1 |
| Source: Zephyr & Associates LLC |
Between 2000 and 2005, investors could assume more conservative positioning in markets like
But globalization also has its downside. As markets mature and become more interconnected with the global economy, they also tend to converge in terms of stock market performance, as Figures 2 and 3 show. Bear in mind that portfolio investors seek value from assets that have relatively low correlation to other assets.
| January 1988 to December 1998 | |||
| Correlation Matrix | |||
| -- | (1) | (2) | (3) |
1. MSCI EM (Emerging Markets) |
1.00 | -- | -- |
2. MSCI EAFE + Canada |
0.47 | 1.00 | -- |
3. S&P 500 |
0.50 | 0.52 | 1.00 |
| Figure 2 |
| Source: Zephyr & Associates LLC |
| January 1999 to July 2008 | |||
| Correlation Matrix | |||
| -- | (1) | (2) | (3) |
1. MSCI EM (Emerging Markets) |
1.00 | -- | -- |
2. MSCI EAFE + Canada |
0.83 | 1.00 | -- |
3. S&P 500 |
0.73 | 0.83 | 1.00 |
| Figure 3 |
| Source: Zephyr & Associates LLC |
Here we use the MSCI EAFE +
Conclusions
The frontier of investment markets is dynamic. As countries grow and mature, they evolve along different risk-return trajectories while other, newer countries emerge to take their place at the frontier. The phenomenon of globalization has resulted in a broad and deep pool of investable markets, while at the same time the tendency toward convergence of stock market performance has lessened the potential diversification benefits available from investing in broadly defined developed or emerging market exposures. Nonetheless, the increased importance of these countries as measured by a number of macroeconomic indicators necessitates their consideration as important additions to investment portfolios.
by
Katrina Lamb
Katrina Lamb is an investment analyst based in Washington, DC, where she researches and advises on portfolio strategies employing a wide range of asset classes and means of investment exposure. Katrina has spent more than 15 years in the investment profession including a great deal time of living and working overseas in markets such as Japan, Southeast Asia, Central and Eastern Europe and the former Soviet Union. She is fluent in several languages including Russian and Japanese.
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