Stockholm (Ekonamik) – Having spent a week considering frontier markets, it has become apparent that one of the most interesting things about this market segment is its definition. The definition, while clear, appears to lead to a diverse membership. This article considers the history, the definitions and the confusion generated by this fascinating market frontier where many opportunities can be found.
“Frontier Markets may be the least-understood corner of the global equity map,” comments the Ashmore group in an insights note from July 2017, before adding “despite their relatively small size and underdeveloped status, Frontier Markets represent one of the most attractive opportunities for growth and diversification available in the current global environment.” In an enlightening article, Morningstar notes that “there’s no universally embraced definition of what constitutes a developed, emerging, or frontier market. Classification systems vary widely between indexers and benchmarks.”
“Frontier Markets” were invented by the IFC in June 1996, when the subsidiary of the World Bank Group added 14 countries to its monthly index series under that heading, a subcategory of emerging markets at the time. Initially, the term covered Bulgaria Lithuania, Slovakia, Slovenia, Botswana, Ivory Coast, Ghana, Kenya, Mauritius, Tunisia, Bangladesh, Ecuador, Jamaica and Trinidad and Tobago. According to Foreign Policy, the IFC index was eventually acquired by Standard & Poor’s (S&P) in 2000. S&P eventually launched its Select Frontier Index, the first investable index targeting a broad array of frontier equity markets. S&P still offers a wide range of Frontier Market indices. However, the predominant index providers are MSCI and FTSE Russell, both of whom produce a frontier index.
According to MSCI, its Market Classification Framework “aims to reflect the views and practices of the international investment community by striking a balance between a country’s economic development and the accessibility of its market while preserving index stability.” The framework uses economic development, size and liquidity conditions and market accessibility conditions to distinguish between market categories.
However, only the latter two criteria matter when considering the difference between Frontier and Emerging Markets. “The economic development criterion is only used in determining the classification of Developed Markets while that distinction is not relevant between Emerging and Frontier Markets given the very wide variety of development levels within each of these two universes.” As the table below shows, Frontier Markets are less liquid and must meet more modest accessibility conditions.
FTSE Russel;’s methodology is centred around the Country Classification Process at the core of which lays the Quality of Market Matrix, which guides a country’s inclusion in FTSE Russell’s Developed, Advanced Emerging, Secondary Emerging, or Frontier markets. The quality of market criterion is further decomposed into 23 different considerations regarding per capita income, creditworthiness, market and regulation, custody and settlement, the dealing landscape and the maturity of derivative markets.
Of all of these, it seems that only five criteria are actually material to Frontier Market determinations. First, the country must have a formal stock market regulatory authority that actively monitors market such as the SEC, the FCA, or Finansinspektionen in the USA, UK and Sweden, respectively. There must also be no objection to or significant restrictions or penalties applied to the investment of capital or the repatriation of capital and income by foreign investors. With regards to settlement, failed trades must happen very rarely while clearing and settlement must take place within two to three weeks. Finally, market information/visibility and a timely trade reporting process are necessary to ensure market transparency.
The confusing outcome of these different processes is patent in the final selection. As the table below shows, there are 9 countries that are covered by either of the two index providers that the other does not include as of April/May 2019.
Sources: MSCI Frontier Market Index Factsheet (30/04/2019) and FTSE Frontier Index Series – Ground Rules – Eligible Countries (May 2019)
Another issue that is not always evident is what the trigger is for upgrades. For example, Ekonamik was not able to find a motivation for MSCI’s recent May 13th decision to upgrade Argentina from its Frontier Market index to its Emerging Market index. According to Highland Capital Management, the Argentinian equity market already met MSCI’s accessibility conditions in June 2018 and the index provider was impressed with President Macri’s reforms and his unwillingness to employ capital controls to limit currency devaluation but decided to hold back on the upgrade to see how sustainable these reforms were and whether they would last. Moreover, in its 27 September 2018 decision to upgrade Iceland to frontier market in September 2019, FTSE mentioned only the country’s removal of capital controls from equities ownership.
Asides from the disparities in coverage, both index providers include a pretty eclectic mix of countries under the Frontier heading. As Mattias Martinsson, Chief Investment Officer (CIO) at Tundra Fonder told Ekonamik, “we do not think that the story of Pakistan, Egypt, Nigeria or Vietnam has much in common with the story of Iceland or Estonia.” Due to this lack of coherence many asset managers apply a fluid definition of Frontier and Emerging Markets in their coverage.
The Risk Premium
As Ekonamik noted in January, the main deterrent against Frontier markets is their risk. For investors primarily guided by credit rating classifications, Frontier markets present a concerning prospect given typically non-investment grade credit ratings. At the time we noted the example of Aberdeen’s funds, whose Frontier Markets Bond fund has a “highly speculative” “B” rating while the Emerging Markets Local Currency fund enjoys a Lower medium investment grade rating of “BBB”. The frontier market fund is six grades below the emerging market. At the time, we also noted that based on following the MSCI definitions and based on the MSCI definitions and on the Canadian Central Bank’s CRAG sovereign default dataset, between 1960 and 2016, the rate of years in default for Frontier market countries was 43.25% whereas it was 25.12% for Emerging market countries.
Ultimately, frontier markets appear to simply be the bottom layer of market classifications; a place for index providers to huddle countries not entirely ravaged by war, illness, famine or capital controls but that do not quite fulfil the conditions for membership into their emerging market indices. It is not a very satisfying definition and this “by default” approach clearly lacks the flair that the term “frontier” invites. Indeed, the more accurate image might be that of a country climbing its way out of a hole, just over the edge of recent troubles rather than one exploring new frontiers. Indeed the frontiers being explored are old ones, which the experienced investors with a track record in other emerging markets and a taste for economic development and history might be able best suited to explore.
Picture from Pixabay