In a world witnessing the migration of economic power and opportunity, emerging and frontier markets around the world have become an established component of an institutional investment plan.
However, there is growing recognition not only that traditional approaches to emerging markets (such as investing via market capitalization indexes or investing in actively managed global emerging market funds) may have limitations, but also that markets outside those currently dominating traditional benchmarks may provide compelling opportunities to investors.
Horizon markets—those believed to be next to emerge as attractive areas for investment—constitute an entire investable universe comprising smaller emerging markets and frontier markets that are underrepresented, poorly understood, inadequately researched and, in many cases, excluded from investment.
Presently, there is an initial investable universe of 40 horizon markets outside of the seven largest emerging markets: Brazil, Russia, India, China, Korea, Taiwan and South Africa. These horizon markets—including countries such as Indonesia, Chile and Kenya—are home to almost 1,000 stocks, a market capitalization of more than $3 trillion and a daily traded value of $4.8 billion.
Over the past 10 years, these markets have shown higher returns and lower volatility when compared to either the MSCI Emerging Markets or MSCI Frontier Markets indexes. Given these risk/return characteristics, mean variance efficient portfolio construction may be significantly improved through exposure to an actively managed strategy that provides access to these smaller emerging and frontier markets and provides a case for asset allocators to consider rethinking their traditional frameworks and the role of traditional indexes.
In general, the flow of investment capital tends to be heavily skewed toward the seven largest emerging markets, while the remaining 14 countries represented in the MSCI Emerging Markets Index receive little dedicated investment in most traditional asset allocation exercises. Of 21 countries in the index, the seven largest markets account for approximately 80.0% of the index.
Traditional market capitalization-based approaches inevitably limit the universe available to investors, concentrate exposure in a handful of countries (whether in the MSCI Emerging Markets or the MSCI Frontier Markets indexes) and fail to deliver on either diversification or consistent long-term capital appreciation.
Capitalization weighting is also inflexible in expressing forward-looking views, and index security selection rules do not capture the complete opportunity set, which may lead to unnecessary volatility in allocations.
When it comes to the more recent interest in frontier markets (and focusing specifically on Africa), the problems prove even more acute. As a result, investors expecting diversification and risk reduction through an allocation to a frontier markets-indexed investment run the risk of experiencing a lack of expected diversification with increased volatility.
The drivers sought out by emerging market investors—a package of growth, potential currency appreciation over the long term and reflationary pressures on prices in an environment of domestic demand, a rising middle class and growing urbanization—are potentially even greater in horizon markets.
Yet, given that these markets typically lie beyond most investors’ mainstream investment horizon, what is the best means of accessing this opportunity? An optimal approach for investors seeking to build out thoughtful exposure to the smaller emerging and frontier markets may increasingly lead to a recasting of the traditional index framework.
Used to complement existing allocations to large emerging markets, dedicated allocations to benchmark-agnostic investment strategies focused on these smaller emerging markets may offer investors a fresh perspective on their emerging market allocations.
Kemal Ahmed is a portfolio manager with Investec Asset Management email@example.com