Our guide to the new investment destinations
As traditional emerging markets begin to take on some of the risk and return characteristics of their developed counterparts, many investors are turning their attention to nascent equity markets to replace them on the efficient frontier curve. ‘Frontier’ is a good term to describe these rather disparate markets that are characterised by high volatility, low liquidity and sometimes spectacular performance returns. Frontier markets differ greatly from one another in terms of capitalisation and economic development, as measured by World Bank gross national income (GNI).
There are a number of reasons for the interest in frontiers. Index investors are seeking the diversity and significantly less correlation against emerging and developed segments of their portfolios, where diversification effects are beginning to blur. Investors who have found emerging markets a safe harbour in the wake of the western credit crisis are emboldened and are now venturing further afield into the frontier. The same is true for investors seeking diversification in some of the frontier countries that have commodity-based economies. Other investors are pursuing secular growth in oil-rich Middle Eastern markets or are trying to capture local consumer-led growth in countries such as Nigeria. Diversification benefits exist – for example, Nigeria’s equity market, dominated by the banking sector with the backdrop of an oil economy, has little correlation with Croatia or Sri Lanka.
Economic and regulatory reforms are taking hold as the frontier countries have been beneficiaries of international organisations such as the World Federation of Exchanges, regional stock exchange associations, IOSCO, CESR, ISSA, and the Bank for International Settlements. These organisations have ushered in the standardisation of existing equity markets and the rapid development of frontier and emerging market stock exchanges. Working with financial and academic support from agencies such as the World Bank, IMF, OECD, and the US Agency for International Development, they have helped frontier countries and newly opened stock markets to develop the necessary regulatory, legal, clearing and settlement systems needed to attract foreign portfolio capital. Most recently, the diffusion and availability of trading technology platforms and electronic communication has further enabled market infrastructure development. Because of the small size of many of these markets, liquidity remains an issue.
How do you know you’ve reached the frontier?
Though most index providers agree on what developed markets are, consensus declines as you move along the spectrum away from the developed category, through the emerging category towards the frontier tail. This stems from the need to include hot or rapidly growing, highly capitalised markets for performance bets and/or because inflexible country categorisation systems lack a disciplined methodology. In many ways the frontier markets of today are similar to the emerging markets of 10 years ago.
the frontier markets of today are similar to the emerging markets of ten years ago.
It’s clear, then, that it is beneficial for investors to have at their disposal a robust and objective country classification definitional system that can be used to assign countries to developed, emerging and frontier categories within a global benchmark. With such a system in place, investors can gain a more objective understanding of the risk and return profile of markets in which they are considering investing.
Key features for a country classification system
A country classification system should be robust enough to span the continuum from a developed category to emerging, to frontier, and then beyond. Furthermore, it should allow for the promotion and demotion into and out of these categories. Finally, there should be an engagement process whereby the needs of international investors are communicated to the exchanges and regulatory authorities of the countries in the form of rules or criteria.
FTSE uses a comprehensive, rules-based approach to country classification, alongside an ongoing market-wide engagement process, making it well positioned to define what constitutes a developed, emerging or frontier market. Recent events have reminded us only too clearly that markets are in a constant process of change, and so for a country classification system to be truly accurate, it needs to be updated regularly. FTSE reviews markets on an annual basis against the quality of market criteria and publishes the results in a transparent matrix format. Results of the September 2008 Country Classification Review can be found at www.ftse.com/country.
Changes approved at this review included South Korea winning promotion to developed status, and a new set of eight markets being added to the watch list for possible promotion or demotion next year. These are the markets with which FTSE will engage over the next 12 months, bringing together asset managers, investment banks, exchanges and regulators to improve knowledge and understanding of the barriers to efficient international investment across markets. The dialogue is facilitating major improvements in market practice with real benefits to all participants – whether international investors, or domestic markets’ exchanges and their regulators.
A good analogy to underline the need for a consistent and codified country classification system is that of sector classification – systems such as ICB are used by investors everywhere to decide which sector a company belongs to. This enables them to analyse and track their portfolios on a like-for-like basis. It’s a natural progression to expect an established framework for country classification within equity benchmarks, not only to compare like with like – emerging market with emerging market – but also for investors to understand the risk profile of new frontier markets, such as Nigeria or Vietnam, and to be confident and comfortable about decisions to include these new markets within portfolios.
Benchmarking can make a valuable contribution to investors’ need for a standardised framework for equity market classification. It’s worth examining how your index provider approaches this important decision in the investment process, as you consider whether to venture towards the new frontiers.
Full details of FTSE’s country classification framework for equity markets can be found at
www.ftse.com/country.
This includes an assessment on the quality of markets for
each market contained within the FTSE Global Equity Index Series. To receive the country classification report please visit
www.ftse.com/country.
For more information email info@ftse.com
Mark Makepeace
