The changing number of countries that have a frontier market classification, has had ramifications for how active managers build their portfolios.
One of the key index providers, MSCI, has made a number of changes in recent years which involved countries such as the UAE and Qatar being promoted to the mainstream MSCI Emerging Market index.
The two countries accounted for 30%-40% of the MSCI Frontier Markets index in 2014 and the subsequent change had an impact on liquidity and market cap of the index. Pakistan, which was around 10%, was reclassified as a mainstream market in June 2017.
Argentina will be reclassified from frontier markets to emerging markets status in May 2019. In addition, MSCI announced that it will include Kuwait in its 2019 annual market classification review for a potential reclassification to emerging markets status. This has not coincided with other liquid countries entering the frontier space over the same period.
Given the potentially reclassified countries make up a big chunk of the MSCI Frontier Markets index, e.g. Argentina 18.7%, Kuwait 20% as of 31 July 2018, fund managers, especially those in some form constrained by their index, will be forced into significantly less liquid and developed countries.
In effect, the frontier market index has been turned on its head from where it was four years ago.
How Have Fund Managers Reacted?
Portfolio managers have started to refine their approaches and a number have decided to move away from the “upgrade-downgrade cycle” of the index provider. They’ve lived through the changes and want to create a more stable and consistent universe, by changing the benchmark and investment remit.
A few managers adopted some form of the MSCI Frontier Emerging Markets index which adds five emerging-market “crossover” countries - the Philippines, Colombia, Egypt, Pakistan, and Peru. For example, Templeton Frontier Markets, Neutral-rated by Morningstar, changed the benchmark from the MSCI Frontier Markets index to the customized MSCI Frontier Emerging Markets Countries Capped index.
Exposure to the emerging-market “crossover” countries is capped at 30% and each country at 10%, with the exception of the Philippines which is capped at 15%. If not capped, the “crossover” countries have a large weight of almost 50%.
HSBC GIF Frontier Markets fund, rated Neutral by Morningstar, uses the custom benchmark which was exclusively devised in tandem with MSCI – the MSCI Select Frontier & Emerging Markets Capped index. It includes 23 frontier markets within the MSCI Frontier Markets index, as well as seven emerging-market “crossover” countries that the managers believe are frontier in nature; Philippines, Colombia, Egypt, Pakistan, Peru, UAE and Qatar.
The emerging-market “crossover” exposure is capped at 30% with a 10% cap for each country. This way the managers tried to remove the structural biases inherent in the publicly available frontier markets indices: high concentration to Kuwait and Nigeria in the MSCI Frontier Markets index and high concentration to “crossover” emerging market countries in the MSCI Frontier Emerging Markets index.
From 1st April 2018, shareholders of BlackRock Frontiers (BRFI) investment trust, which is also rated Neutral by Morningstar, voted to adopt a recommendation from the board to widen its remit to include some emerging-market countries. This will include 16 smaller emerging-market countries and so excludes the eight largest constituents of the MSCI Emerging Market index.
The investment trust will now be benchmarked against the bespoke index called the MSCI Emerging Markets ex Selected Countries + Frontier Markets + Saudi Arabia Index. The managers believe that many of the attractive properties that initially drew investors to frontier markets, namely the lower valuations, higher yields and lower correlations remain true in this expanded universe.
The majority of fund managers, however, continue using the MSCI Frontier Markets index as their prospectus benchmark as it tends to be more recognised by their clients, although they don’t consider it particularly reflective of their addressable universe.
Given the variability of the opportunity set, managers are allowed flexibility when it comes to defining their universe and can have significant off-benchmark exposure. They can invest in any “pre-emerging” country as long as it has characteristics of a frontier market, although the criteria and definition of a frontier market can also differ depending on the manager and index provider.
According to Morningstar data many funds in the frontier markets peer group have considerable off-benchmark exposure. For example, as of 31 July 2018 top-performing Magna New Frontiers fund had 20.5% in UAE, 19% in Saudi Arabia and 4% in Poland, while Schroder ISF Frontier Markets Equity fund invested 11% in Egypt, 9% in UAE and 4% in Saudi Arabia.
Despite the changes that fund managers are undertaking, Morningstar believes it pays to go active when investing in frontier markets. It is hard to invest passively in this asset class given the difficulty of tracking these relatively illiquid markets, as well as high tracking costs.
For example, the only ETF available to European investors - X S&P Select Frontier Swap ETF, which tracks the S&P Select Frontier index - has estimated tracking difference of 2.4% and transaction costs of almost 1.5% on top of TER of 0.95%. In addition, active managers are able to benefit from diversification, market inefficiencies, low analyst coverage, as well as screening for corporate governance issues.
A version of this article first appeared in Investment Week
