Insight: Refuge may be found via new frontiers

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Global equity markets are experiencing dramatic volatility. During December and January, the MSCI All-Country World Index, which includes both the developed markets and the emerging markets fell close to 10 per cent in US dollar terms. The MSCI World index which includes only the developed markets around the world was down 8.8 per cent during the last the two months. The MSCI Emerging Market Index was down 12.1 per cent.

Investors will be excused for asking if there are any equity markets that offer relative protection from this turmoil.

We would point to those frontier markets that remain below the radar screen of global capital flows as potential sources of low correlation with the larger developed markets.

Frontier markets are defined as those markets that tend to have a smaller capitalisation, fewer securities traded and are less liquid even than emerging markets. They are composed of countries exhibiting different levels of economic development. Some of the frontier markets have high gross national product per capita, such as the Gulf Countries. Others have low GNP per capita, such as Nigeria and Vietnam.

For December and January, the MSCI Frontier Market Index rose 4.6 per cent. Of course, not all frontier markets rose over the past two months. Some in eastern Europe, including Bulgaria and Romania fell in step with the developed markets and the emerging markets. But most performed better than the developed and emerging markets.

The frontier markets that rose the most were in the Gulf region, including Bahrain which climbed 9.8 per cent, Kuwait, up 14.3 per cent, and Oman, 10.8 per cent. A few frontier markets in the other regions were in demand, including Nigeria, which rose 5.4 per cent.

We have found there is a relationship between increased “foreign ownership” of a stock market and correlation of returns.

As a proxy for “foreign ownership”, we recently investigated, using data supplied by the US Department of the Treasury, US ownership levels of foreign equities from 1994-2006. Notably, on average, for the 47 developed and emerging markets comprising the MSCI All Country World ex-US Index, US ownership of foreign equities has increased from 10 per cent of market capitalisation in 1994 to 24 per cent by the end of 2006. Perhaps not surprisingly, the degree of correlation (36 month trailing) between the MSCI US Index and MSCI All Country World, ex-US Index underwent a sea-change over the same period, breaking out of the 0.3 to 0.6 range in the 1990s, to average above 0.8 over the past five years. (Correlations measure the degree to which two asset classes move together. A correlation of -1 means two asset classes move in opposite directions and a correlation of +1 means that the two assets move completely together.)

Frontier markets, however, remain grossly under-bought relative to their developed and emerging market peers. As a proxy for “foreign ownership”, US ownership represents on average less than 5 per cent of market capitalisation of an amalgam of roughly 30 frontier markets since 1997. Moreover, the correlation of the S&P/IFC Frontier Composite Index with the MSCI US Index remains commensurately low, averaging 0.3 over the past five years.

Using the same US Department of the Treasury data between 2001 and 2006, plotting individual markets shows a linear relationship between US equity ownership and the correlation between each of the markets and the US. The phenomenon of increased foreign equity ownership and increased correlation with the US is evident at individual country level.

The lesson is clear: with increased external participation in foreign markets, correlations rise, and the risk reduction benefits of global diversification can be eroded. The positive relationship between increased US equity ownership and increased correlation with the US is significant.

As such, we counsel those investors seeking volatility reduction to focus some attention beyond the developed markets and even beyond the emerging markets to the frontier markets as the latter have yet to attract the sustained attention of global portfolio investment.

The writer is senior managing director
at Bear Stearns Asset Management

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