Many of you are thinking about investing in frontier markets’ funds, which invest in economies that tend to be less developed and less integrated into the world economy than emerging markets. There might be a case for doing this – but it is not what you think.
One idea you must forget is that poorer countries offer better growth opportunities than richer ones. This is no reason whatsoever to buy their equities. Economists have found no correlation across countries between longer-term GDP growth and equity returns. Faster growth does not mean better returns. In the past ten years, for example, Danish and Dutch equities have out-performed Indian and Chinese ones despite seeing weaker GDP growth.
A moment’s thought will tell you that this shouldn’t be surprising. Insofar as economic growth does benefit listed companies, this should be priced into equities before it happens so it is only unexpected growth that boosts share prices – and pleasant surprises are as likely in mature economies as in poor ones. What’s more, GDP growth needn’t benefit listed firms at all. It might instead be foreign or unquoted firms who see its benefits – or even workers.
That said, there is in theory another case for investing in poor economies’ equities. It’s that for investors in these countries, equities are genuinely riskier because falling prices hurt them more than they hurt those of us in developed economies. If a fall in prices means you having to work a few months longer in a cushy job, it’s unpleasant but tolerable. If, however, it means your children not going to college it is a much nastier prospect. For this reason, many frontier markets are riskier from the point of view of domestic investors and so should offer a higher risk premium than we get in richer countries’ markets.
This seems common sense, doesn’t it?
Which runs into a problem. The facts don’t really support it. Yes, MSCI’s frontier markets index has beaten the All-Share since it began in 2002. But all this outperformance came in 2004-05. Since then, UK equities have done better.
One reason for this is that the marginal investor in such markets isn’t necessarily the rationally risk-averse domestic investor. To the extent that the marginal investor is instead the richer westerner then losses on (say) Bangladeshi equities hurt no more than losses on US equities – and so there won’t be a risk premium on the Bangladeshi market.
We must not, therefore, invest in a stock market because a country is poor.
Indeed, there’s a good reason to avoid them. It lies in the very reason why some countries are poor in the first place. There are many such reasons, such as bad government, corruption or bad neighbours. But the same things that cause a country to be poor can keep it poor or cause political risk or even war. While some frontier markets have recently escaped these chains of history, such as Kenya or Jamaica, others haven’t: the last decade has seen big falls in Ukrainian, Lebanese and Nigerian stocks.
Which brings me to another error. Some of the appeal of frontier markets, I suspect, lies in a whiggish view of history – a presumption that all countries will progress towards affluent, peaceful liberal democracy. But even if the arc of history does bend this way, it is a long arc – longer, perhaps, than your investment horizon.
None of this, however, means we should avoid frontier markets. If you want a passive(ish) portfolio you should have some investment in them. Global investors, on average, attach some value to them – so why shouldn’t you too?
And they do offer a little diversification. Sure, MSCI’s frontier index has underperformed during global disasters such as the financial crisis or the pandemic-induced fall in March. But it held up well during the bursting of the tech bubble in 2002-03. This suggests that such markets can protect us from some types of risk. Not global risks, but localised ones such as those arising from over-valuations. It’s also possible (I’d put it no stronger) that such markets might hold up well amidst fears of secular stagnation in western markets. Such diversification isn’t great – there’s a tight limit to how much you can achieve even with the best diversification among equities – but it’s not nothing.
So, there is perhaps a case for a small investment in frontier markets. It’s just that this case isn’t what you think it is.
