We have not encountered such a lack of confidence in the investment process, the definition of the investment mandate or the choice of benchmark equity index in our institutional clients, in over a decade of conversation with them. This is our impression after the three months of meeting over a hundred individual fund managers and analysts.
This is particularly striking given that there is consensus that the markets they invest in, whether notionally termed “Frontier” or “small Emerging”, are, in general, very attractively valued and the global environment is supportive.
In this report, through the lens of benchmark indices, we consider the crisis of identity and confidence afflicting many in the industry.
A crisis of confidence in the process, rather than the opportunity. Few of the clients we engage with doubt the potential for outsized returns from the “Frontier” asset class (of course, there is, as ever, much debate over exactly where those opportunities are). Valuations have de-rated across the board and most of the vulnerable FX rates have already blown up (e.g. Argentina, Egypt, Ghana, Nigeria, Pakistan, Sri Lanka). We have recently published our views on where the most attractive pockets are in our top-down coverage of 28 markets across Asia, MENA, Africa and LatAm. Markets where economic policy has grown less orthodox, political transition has become riskier and geopolitics has become less supportive are the exceptions, not the rule (e.g. Romania, Turkey, Tanzania, Venezuela). At the same time, the economics and politics of Developed markets have tilted towards the sort of unpredictability (and lower credibility) usually associated with (an increasingly out of date, in our view) perception of Frontier and small Emerging markets.
But almost all the institutional investors we interact with seem unclear as to how to define the “Frontier”, how to build a fund big enough to cover the cost of operating across such diverse and geographically dispersed markets (involving multiple languages and travel spanning, at least, Argentina to Philippines) but small enough to move nimbly, and how to pick winners when changes in the composition of flawed (virtually, broken) benchmark indices are prompting fund flows which overwhelm an active, fundamental investment process based on assessing country risk and bottom-up stock picking. Consider the GCC in 2018, when outperformers were driven not by fundamentals (higher oil price, government spending growth or cheap valuation) but by increasing index weights.
Broken benchmark indices in both FM and EM. This is a challenge as much for those who look at pure Frontier as those that look at any small Emerging market. Once Argentina, Kuwait and Vietnam are “upgraded” out of FM, the remaining, large FM markets (Morocco, Nigeria, Kenya, Bangladesh) look an even sparser representation of “Frontier”. (This would not change even if the likes of Iran, Iraq, Venezuela and Zimbabwe, at some point, joined FM). But after China A shares are ultimately, fully included and make up about half of EM benchmark indices, then the EM benchmark is going to be as broken as the FM one.
The tail of emerging markets that are too small (i.e. excluding BRICS, Korea and Taiwan, which are on a path to constitute over 80% of the MSCI and FTSE EM indices) to make a difference to a global EM portfolio is going to be very long.
For those with sticky capital, flexibility and, of course, good fortune, this situation should scream opportunity. This is because, for a while, this long tail, whether termed Frontier or small Emerging markets, is going to be even more neglected and, therefore, inefficiently priced. In this report, through the lens of benchmark indices, we consider the crisis of identity and confidence afflicting many in the industry.
A reminder of why anyone looks at FM and small EM in the first place. Why should anyone look at these Frontier and small Emerging countries in the first place? Surely not because of the potential to arbitrage upcoming benchmark index constituent changes! But, rather, because, in the long-term, the opportunity for better returns than seen across Developed markets should be driven by:
(1) Faster growth in per capita GDP than that seen in Developed countries (economic “convergence” as property rights are better protected, human, physical and financial capital is more efficiently mobilised and new technology spreads across borders).
(2) For equity investors specifically, by generally, less sophisticated and liquid markets (which create the opportunity to invest in very good companies at prices that insufficiently reflect their outlook in advance of these markets becoming more discovered, accessible, liquid and efficiently priced).
For those without conviction in these core drivers of the long-term opportunity (or for those concerned that multinationals listed in developed markets will gobble up the opportunity and are still at attractive equity valuations) this is not an attractive asset class. For the rest, there are three implications:
(1) The tyranny of existing benchmarks needs to be jettisoned; at least until the providers of those benchmarks do a better job of composing benchmarks more reflective of these two core reasons for investing in these markets in the first place.
(2) The rich Emerging markets (e.g. with GDP per capita above US$15k) perhaps should not be included in the addressable universe (this would exclude markets such as Chile, Czech Republic, Greece, Hungary and the GCC) because they are less likely to exhibit convergence growth characteristics.
(3) Equity funds focused on these markets should not offer the same liquidity (ease of redemption) as those in Developed and the large Emerging markets. How can markets with a fraction of the average daily traded value of Developed and the large Emerging markets support the same redemption terms? Given that outperforming Frontier and small Emerging markets tend to enjoy relatively greater liquidity, a fund focused on this asset class tends to be forced to sell its best performing stocks in response to a redemption; a counter-productive quirk.
Questions for the future of FM and small EM equity funds. Some of the questions prompted by the views expressed above are as follows:
(1) How long is the tail of small Emerging (including Frontier) markets? Is there much point in a multi-billion US$ global EM fund addressing this tail if it merely contributes c20% of their benchmark and does this lack of attention create opportunity?
(2) Is China now so big an economy (in terms of total GDP) that its fortunes impact the rest of the Emerging and Frontier universe (as a buyer of commodities, an investor in infrastructure projects and sovereign debt, a competitor in manufacturing exports and as a part of an integrated supply chain), as much as the US or the EU or Japan, and therefore should China be segregated, as a standalone, distinct from the other Emerging and Frontier markets in any benchmark?
(3) Can passive funds address this tail as effectively as it addresses the Developed and large Emerging markets, when benchmark weights of individual stocks change so dramatically and so often (because of a continual stream of foreign ownership limit increases, IPOs and privatisations, M&A)? Do passive funds end up, more often in small Emerging and Frontier markets, investing in bad companies (because they happen to dominate an index of foreign accessible stocks? Can the actively managed fund arbitrage (and, therefore, outperform) the likely flows from a passive one in advance of well-telegraphed inclusion of countries and stocks in benchmark small Emerging and Frontier market indices (particularly when those markets are still part of indices which include much larger Emerging markets, which distort the impact of funds flows prompted by index constituent changes).
(4) Is small Emerging and Frontier market equity investing much closer to the private equity asset class (stickier, more patient capital) than Developed and large Emerging market equities?
EM benchmark index scenarios. Below we run scenarios of the MSCI and FTSE EM benchmark indices with estimates of how country weights change if China A shares are fully included, if China, Korea and Taiwan are excluded, if the likes of Argentina, Bangladesh, Kenya, Nigeria, Kuwait, Romania and Vietnam are eventually upgraded to EM, and if countries with GDP per capita above US$15k are excluded. These estimates are not precise, but they are intended to show the length of the tail of smaller Emerging markets.
We also show recap the issue of how inadequate is the representation of “Frontier” that remains once the largest constituents of MSCI and FTSE FM are upgraded to EM. Ironically, the proposition of “Frontier” markets, as defined a decade ago, is partly so impaired because the graduation of so many of the larger “Frontier” markets into Emerging (e.g. Argentina, Kuwait, Pakistan, Qatar, UAE).
Ultimately, we argue that it makes more sense to segregate smaller “Emerging markets” from the larger and richer ones and to include the remaining “Frontier” markets as a subset within this. MSCI’s FM-EM and EM Horizon indices probably come closest to this, but both have important shortcomings: FM-EM at least contains Frontier constituents but has too big a weight for Philippines and Kuwait (37% in aggregate) and EM Horizon at least excludes the largest Emerging markets but has no Frontier constituents. Obviously, the definition of large versus small Emerging markets, apart from China, is somewhat arbitrary. In the index scenarios below, the furthest we go is to exclude China, Korea, Taiwan and any market with high GDP per capita.