What do Colombia, the Philippines, Egypt, Turkey, Thailand and Vietnam all have in common? Their stock markets are on a tear this year, delivering total returns of anywhere from 12% to 27%.
They’re also so-called frontier markets, which, while open and investable to mom-and-pop investors, carry special risks.
But now that the economies of the emerging market powerhouses of Brazil, Russia, India and China — the BRICs — are cooling off, investors might need to look to the frontier to find truly outsized gains.
Yes, the darling of the developed world, the U.S. stock market, has been a better bet than other big, rich-world countries in 2012. Taking the widest range of stocks into account and including dividends, U.S. equities have returned 6.5% for the year-to-date, according to S&P Broad Market Indices. Meanwhile, the U.K is up less than 1%, German stock are flat, Japan has lost 2.4% and France is off 3.6%.
U.S. equities are beating the once-irresistible BRICs, too. Brazil’s total year-to-date return comes to a negative 8.5%, according to S&P BMI. Russia has lost 3.3%, India is up only 4.9% and China has returned just 2.6%. It used to be that U.S. investors allocated a fraction of an equity portfolio to emerging markets to juice returns — but now those same nations are actually acting as a drag.
That makes at least some small exposure to frontier markets look pretty good — it’s where some serious outperformance can be found. For example, Vietnam is up 27% on a price basis, while the Philippines and Egypt have returned more than 20% this year. Turkey and Thailand have generated total returns of 18% and 14%, respectively. Colombia is up more than 12%.
And, almost counterintuitively, a prudent allocation to riskier frontier markets can actually lessen the overall risk profile of a properly diversified portfolio.
“In a global macro environment dominated by uncertainties, frontier markets’ relatively low correlation with developed (and emerging) markets offers investors significant potential diversification benefits,” write Schroder Investment Management’s Allan Conway and Edward Evans in a new paper.
Frontier economies are at the early stage of development and are expected to grow faster than emerging and developed economies, the authors note. Not adjusted for inflation, frontier economies’ gross domestic product comes to only about $3 trillion, or approximately 4.2% of global GDP. As is the case with small-cap stocks, that leaves plenty of room to run.
Indeed, frontier economic growth is forecast to grow 6% a year over the near term, say Conway and Evans. That’s similar to emerging market growth (at least before the global slowdown), and far faster than growth in developed markets. The U.S., for example, is currently growing at less than a 2% annualized rate, while much of Europe has slipped back into recession.
Conway and Evans argue that slow growth in the developed world, with its bloated balance sheets, actually makes frontier countries less risky investments. Frontier economies are typically strong, the authors write, with low public debt levels. Developed economies, meanwhile, are floundering under unsupportable debt burdens. (Just have a look at Spain and the recent spike in its borrowing costs.)
The easiest, cheapest and most liquid way to invest in frontier markets is through exchange-traded funds. But beware: The offerings are still somewhat limited, and the funds are still comparatively small when it comes to assets under management.
For broad diversification, investors might want to wait for MSCI Inc. (NYSE:MSCI) to launch its new MSCI Frontier Markets 100 Index. MSCI announced this spin-off of its broader MSCI Frontier Markets Index back in April. It’ll comprise 100 of the Frontier Markets Index’s largest and most liquid companies, which, in turn, will form the basis for a future BlackRock (NYSE:BLK) iShares ETF.
Until then, investors will have to make do with something of a hodgepodge of offerings. The Guggenheim Frontier Markets ETF (NYSE:FRN) is heavily weighted toward South America, with Colombian and Chilean stocks among the top holdings.
Market Vectors Vietnam ETF (NYSE:VNM) is a pure play on Vietnam’s torrid growth. The WisdomTree Middle East Dividend Fund (NYSE:GULF), PowerShares MENA Frontier Countries ETF (NYSE:PMNA) and Market Vectors Africa Index ETF (NYSE:AFK) are not only plays on oil, but also on regional telecoms and financial services.
Conway and Evans argue that frontier markets are the new emerging markets. If they’re right, so much the better. When it comes to stocks, the world has become a tough place to find outsized returns.