In the last four years, the frontiers market index has been turned on its head and active managers have had to react changes in how countries are classified. Despite these changes and complexities, Morningstar believes it pays to go active when investing in frontier markets.
One of the key index providers, MSCI, has made a number of changes in recent years that will affect liquidity, benchmarking and the investment remit of emerging markets/frontiers funds.
The United Arab Emirates and Qatar are two such “crossover” countries that have been 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. MSCI also 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 – for example, Argentina at 18.7%, Kuwait at 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 lee-developed countries.
Portfolio managers have started to refine their approaches, and a number have decided to move away from the upgrades and downgrades of the index provider. They have lived through the changes and want to create a more stable and consistent universe by changing the benchmark and investment remit.
Changing the Benchmark
A few managers adopted some form of the MSCI Frontier Emerging Markets Index, which adds five emerging markets “crossover” countries – the Philippines, Colombia, Egypt, Pakistan, and Peru. For example, Templeton Frontier Markets, which has a Morningstar Analyst Rating of Neutral, changed the benchmark from the MSCI Frontier Markets Index to the customised MSCI Frontier Emerging Markets Countries Capped Index. Exposure to the emerging-markets “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 a custom benchmark that 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 markets “crossover” countries that the managers believe are frontier in nature: Philippines, Colombia, Egypt, Pakistan, Peru, UAE, and Qatar. The emerging-markets “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 indexes: high concentration to Kuwait and Nigeria in the MSCI Frontier Markets Index and high concentration to “crossover” emerging-markets countries in the MSCI Frontier Emerging Markets Index.
From 1 April 2018, shareholders of BlackRock Frontiers investment trust (BRFI), which is also rated Neutral by Morningstar, voted to adopt a recommendation from the board to widen its remit to include some emerging-markets countries. This will include 16 smaller emerging-markets countries and so excludes the eight largest constituents of the MSCI EM 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 lower valuations, higher yields, and lower correlations, remain true in this expanded universe.
MSCI Frontiers Index Recognised by Clients
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 exchange traded fund available to European investors – Xtrackers S&P Select Frontier Swap ETF (XSFR), which tracks the S&P Select Frontier Index – has an estimated tracking difference of 2.4% and transaction costs of almost 1.5% on top of a total expense ratio of 0.95%. Active managers also benefit from diversification, market inefficiencies, low analyst coverage, and by screening for corporate governance issues.
