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Frontier Markets Accessing the Next Frontier

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Frontier Markets Accessing the Next Frontier Research Frontier Markets Accessing the next frontier ftserussell.com September 2014 Executive summary Frontier Markets constitute the one segment of the equity market that is typically missing within institutional portfolios. These markets represent developing countries with high rates of economic growth, but small and relatively illiquid stock markets. Frontier Markets are often in their infancy and have attracted attention due to their diversification opportunities and growth potential. Equities listed in Frontier Markets have become increasingly investable, attracting investors that are looking to benefit from early-adopter status in an asset class that some participants believe has the potential to become a significant portion of the global equity opportunity set. Attractive economic fundamentals • Higher historic GDP growth rates than their Developed and Emerging counterparts. • Favourable demographics underpinned by a relatively large and young population. • Relatively strong fiscal position. • Rapid urbanization and technological advances, coupled with low labour costs make Frontier Markets attractive destinations for manufacturing hubs. Lower volatility than perceived • Many investors ignore Frontier equities as they are perceived to be too risky and volatile. However, Frontier Markets have historically been less volatile than both Developed and Emerging Markets. Diversification • A significant challenge for investors in recent years has been the increasing correlations between asset classes. As traditional Emerging Markets have developed, the correlation between Emerging and Developed Market securities has converged. • Frontier economies remain more local in character, illustrated by the low correlation with Developed and Emerging Markets. Additionally, Frontier Markets have low correlations with each other, providing further opportunities for diversification. Valuations remain relatively low • Frontier Markets trade at a discount to both Emerging and Developed Markets. • Despite relative higher performance over the past three years, Frontier Markets still trade at a lower PE than their Emerging Market counterparts. FTSE Russell | Frontier Markets 1 A. Introduction to Frontier Markets Frontier markets constitute the one segment of the equity market that is typically missing within institutional portfolios. They represent developing countries with high rates of economic growth but small and relatively illiquid stock markets. These markets are often at an early stage of development and have attracted attention due to their diversification opportunities and growth potential. Equities listed in Frontier Markets have become increasingly investable, attracting investors looking to benefit from early-adopter status in an asset class that some participants believe has the potential to become a significant portion of the global equity opportunity set. All markets were once considered Frontier prior to undergoing economic reform, developing infrastructure, and building platforms and regulations for share trading. 220 years ago the New York Stock Exchange was created under a buttonwood tree in order to facilitate trading amongst brokers in just a handful of listed companies. At the time no one could foresee the United States in its infancy would grow to become today’s largest economy. As recently as 1980, China was widely considered a Frontier Market but is today the second largest economy in the world. Some Frontier Markets did not even exist a decade ago. However, many now benefit from the same technology and exchange platforms used by developed nations that can support and promote rapid growth. Of course there are examples in Argentina and Venezuela (the latter removed from FTSE indexes in 2003) that illustrate slow transitions, and even regression. However the trend over time has been towards global growth and open access to financial markets. If this trend continues, the Frontier Markets of today could become the Developed Markets of tomorrow. Frontier classification People tend to associate Frontier Markets with low income developing countries but according to the World Bank1, the per capita Gross National Income (GNI) of Frontier countries range from high income (> $12,476) to low income (< $1,045) as of year-end 2013. For example, in 2013 Qatar was ranked second in the world with a GNI Per Capita of $85,550, while Bangladesh recorded a GNI Per Capita of $900. Country Classification is largely independent of GNI or economy size, and instead focuses on a country’s political and market environment. Classification criteria include the depth and breadth of financial markets, legal and regulatory infrastructure, and general ease with which foreign investors can do business. Diversification A major challenge for investors in recent years has been the rising correlations between asset classes, which have reduced diversification. As the traditional Emerging Markets have developed and become more entrenched in global trade, they have begun to take on similar risk and return characteristics as their Developed counterparts. This is illustrated by the convergence, in recent years, of the correlation of the FTSE Developed All Cap Index with the FTSE Emerging All Cap index. 1 http://data.worldbank.org/about/country-and-lending-groups FTSE Russell | Frontier Markets 2 Emerging and Developed Correlation Convergence 0.9 0.8 0.7 0.6 0.5 0.4 0.3 0.2 0.1 0.0 Dec 03 Dec 04 Dec 05 Dec 06 Dec 07 Dec 08 Dec 09 Dec 10 Dec 11 Dec 12 Dec 13 Rolling Daily Correlation *Correlation calculated using rolling daily total returns annualized based on 252 trading days in a year Source: FTSE, data as at June 30, 2014. Past performance is no guarantee of future results. Please see the disclaimer page for important legal disclosures. The 5 year correlation (using monthly index returns) was 0.87 as of June 30th 2014. Frontier Markets, on the other hand, remain more local in character, heavily driven by internal economic and political dynamics. The 5 year correlation of the FTSE Frontier Index with the FTSE Developed All Cap and Emerging All Cap indices remain relatively low at 0.58 and 0.52 respectively as of June 30th 2014. Furthermore, Frontier Markets have relatively low correlations amongst each other. This is highlighted by cross-country correlation between Frontier Markets of 0.30 compared with 0.52 for Emerging and 0.70 for Developed. Thus, a Frontier Markets Index offers diversification and low correlation to other asset classes held in a typical index. FTSE FTSE All Cap FTSE All Cap 1 year correlation Frontier Index Emerging Index Developed Index FTSE Frontier Index 1.0000 0.4963 0.4228 FTSE All Cap Emerging Index 1.0000 0.7707 FTSE All Cap Developed Index 1.0000 *1 Year Correlation using daily data FTSE FTSE All Cap FTSE All Cap 3 year correlation Frontier Index Emerging Index Developed Index FTSE Frontier Index 1.0000 0.5543 0.5593 FTSE All Cap Emerging Index 1.0000 0.8653 FTSE All Cap Developed Index 1.0000 **3 Year Correlation using weekly data (Wednesday to Wednesday) FTSE Russell | Frontier Markets 3 FTSE Frontier FTSE All Cap FTSE All Cap 5 year correlation Index Emerging Index Developed Index FTSE Frontier Index 1.0000 0.5132 0.5772 FTSE All Cap Emerging Index 1.0000 0.8765 FTSE All Cap Developed Index 1.0000 ***5 Year Correlation using month end data Source: FTSE, data as at June 30, 2014. Past performance is no guarantee of future results. Please see the disclaimer page for important legal disclosures. Academics Additionally, some academic studies may present an argument for Frontier Markets’ inclusion. For example, the Modern Portfolio Theory (Markowitz 1952) quantifies the benefits of diversification by illustrating the potential for higher returns and lower risk that can be achieved by spreading investments across a larger opportunity set. Furthermore, according to the Efficient Market Hypothesis (Eugene Fama), you cannot beat the market since current prices reflect all available information. The Efficient Market Hypothesis argues that only the “market” portfolio is efficient, and as Frontier Markets represent 1% of total global market cap and 4% of global GDP, it can be argued that Frontier Markets should represent at least a similar allocation in diversified portfolios. In many ways, Frontier Markets offer a natural evolution for investors who have already embraced the Emerging Markets, and are looking for additional potential high growth opportunities that may increase diversification. Many market participants believe that these markets have the potential to grow at a faster rate than the rest of the global economy in the future by becoming more efficient, improving their infrastructure, and developing more robust regulatory and capital investing frameworks. B. Economic fundamentals Economic growth Investors have been attracted to the high growth rates of Frontier Markets in recent years, and the International Monetary Fund (IMF) estimates that Nominal and Real GDP growth will continue to be higher in Frontier Markets than the more advanced economies for decades to come. FTSE Russell | Frontier Markets 4 GDP Growth 5% 4% 3% 2% 1% 0% Developed US Emerging Frontier I GDP Growth (%) I Projected GDP Growth (%) *Source World Bank as at September 30, 2012 (2007 - 2012 actual GDP growth) and IMF (Projected GDP growth 2012 – 2020). Past performance is no guarantee of future results. Please see the disclaimer page for important legal disclosures. Favourable demographics The strong growth of Frontier countries is underpinned by their large
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