1Source: Acadian. Correlations referenced on a monthly basis over the trailing 10-year period.
Asha Mehta, CFA
Senior Vice President, Portfolio Manager
In the trailing 12 months, frontier equities have notably outperformed emerging equities ahead of the EM index by 8.6%.* Portfolio Manager Asha Mehta discusses some of the forces driving this differential in the current environment and reiterates Acadian’s philosophy that frontier equities merit inclusion in an asset allocation strategy as a reasonable-risk, diversifying, and highly inefficient segment of the market.
Why are Frontier Markets Leading Emerging Markets This Year?"
Top-performers in the MSCI Frontier Markets index over the past year include representatives from Eastern Europe (including Croatia and Romania), as well as Argentina and Morocco. On the emerging side, all markets have realized negative market performance with the exception of Hungary. China’s performance has been particularly grim, trailing the broader EM index by 10.9% with a -28.5% return over the trailing 12 months, while representing 23.6% of the index.*
Behind the relatively steady frontier performance trend, we see a few key themes playing out. First, fundamentals appear strong throughout much of the asset class. We find that these markets are ripe for earnings expansion, multiple expansion, and capital deepening. Frontier countries are not only growing faster than emerging countries, frontier companies are also growing faster than emerging companies. At the start of the year, analysts expected near-zero FY1 earnings growth for emerging companies, while they expected growth among frontier companies in the double digits.
Beyond this, individual country-level fundamentals are supportive in many cases. For the Eastern European markets I mentioned earlier, we have seen limited sociopolitical risk along with concerted efforts to build the private sector, increase foreign investment, and improve corporate growth and earnings. Morocco is supported by stable growth in a relatively peaceful, low-risk African nation with exposure to rapid development in the francophone regions of North Africa. Meanwhile, Argentina is buoyed by the newly elected technocratic president’s reforms, which are relaxing capital controls and supporting the business environment—leading to speculation about potential inclusion in the MSCI EM index.
How do drivers of returns differ in these markets?
The country-specific nature of frontier fundamentals contrasts markedly with the case in emerging markets, where pervasive concerns about China seem to be dampening sentiment across the asset class. We see evidence of this in a couple of aspects of emerging markets’ performance.
First, drivers of returns. It is fair to say that global themes, including oil prices, matter more to emerging markets than to frontier—as evidenced by the higher long-term correlations between developed and emerging than we have seen between developed and frontier markets. We can take this a step further by examining the broader co-movement across emerging markets. Over the trailing 12-month period, China led performance downward, driving nearly all emerging market countries into negative territory, particularly neighboring Taiwan and South Korea.
This trend contrasts with frontier markets. To be clear, there are examples of distress within frontier. Nigeria, for example, likely faces a material currency devaluation given their oil dependence and bleak macroeconomic backdrop. But we don’t see material risk of contagion from these cases. And the diversification benefit of low correlations among frontier markets held up even over the past year when global markets were under stress. Well diversified frontier portfolios exhibited a fraction of the volatility of emerging market returns.
Consistently, returns in emerging countries co-move together more than frontier returns do. In emerging markets, the pairwise correlation of returns is approximately 0.55, contrasting with approximately 0.28 in frontier markets, where country drivers tend to be more idiosyncratic and country-specific.1
What about current valuation levels?
Frontier markets continue to trade at a discount to their emerging peers. Despite stronger company-level fundamentals, some valuation discount is warranted based relative liquidity. But we think the gap is too wide given current market and political risk.
At the start of the year, frontier markets traded at 10.0x trailing PE, while emerging markets traded at 12.9x. As shown below, this discount is steeper than the average discount since inception of the MSCI Frontier index in 2007 and has created what we see as an attractive entry point for frontier markets investors.
Source: MSCI Frontier Markets, MSCI Emerging Markets. Copyright MSCI 2015 All Rights Reserved. Unpublished. PROPRIETARY TO MSCI.
1Source: Acadian. Correlations referenced on a monthly basis over the trailing 10-year period.
For institutional investor use only. Not to be reproduced or disseminated. For illustrative purposes only. This should not be considered a recommendation to buy or sell any specific security.
General Legal Disclaimer
Acadian provides this material as a general overview of the firm, our processes and our investment capabilities. It has been provided for informational purposes only. It does not constitute or form part of any offer to issue or sell, or any solicitation of any offer to subscribe or to purchase, shares, units or other interests in investments that may be referred to herein and must not be construed as investment or financial product advice. Acadian has not considered any reader’s financial situation, objective or needs in providing the relevant information.
The value of investments may fall as well as rise and you may not get back your original investment. Past performance is not necessarily a guide to future performance or returns. Acadian has taken all reasonable care to ensure that the information contained in this material is accurate at the time of its distribution, no representation or warranty, express or implied, is made as to the accuracy, reliability or completeness of such information.
This material contains privileged and confidential information and is intended only for the recipient/s. Any distribution, reproduction or other use of this presentation by recipients is strictly prohibited. If you are not the intended recipient and this presentation has been sent or passed on to you in error, please contact us immediately. Confidentiality and privilege are not lost by this presentation having been sent or passed on to you in error.
Acadian’s quantitative investment process is supported by extensive proprietary computer code. Acadian’s researchers, software developers, and IT teams follow a structured design, development, testing, change control, and review processes during the development of its systems and the implementation within our investment process. These controls and their effectiveness are subject to regular internal reviews, at least annual independent review by our SOC1 auditor. However, despite these extensive controls it is possible that errors may occur in coding and within the investment process, as is the case with any complex software or data-driven model, and no guarantee or warranty can be provided that any quantitative investment model is completely free of errors. Any such errors could have a negative impact on investment results. We have in place control systems and processes which are intended to identify in a timely manner any such errors which would have a material impact on the investment process.
Acadian Asset Management LLC has wholly owned affiliates located in London, Singapore, Sydney, and Tokyo. Pursuant to the terms of service level agreements with each affiliate, employees of Acadian Asset Management LLC may provide certain services on behalf of each affiliate and employees of each affiliate may provide certain administrative services, including marketing and client service, on behalf of Acadian Asset Management LLC.
Acadian Asset Management LLC is registered as an investment adviser with the U.S. Securities and Exchange Commission. Registration of an investment adviser does not imply any level of skill or training.
Acadian Asset Management (Japan) is a Financial Instrument Operator (Discretionary Investment Management Business). Register Number Director General Kanto Local Financial Bureau (Kinsho) Number 2814. Member of Japan Investment Advisers Association.
Acadian Asset Management (Singapore) Pte Ltd, (Registration Number: 199902125D) is licensed by the Monetary Authority of Singapore.
Acadian Asset Management (Australia) Limited (ABN 41 114 200 127) is the holder of Australian financial services license number 291872 (“AFSL”). Under the terms of its AFSL, Acadian Asset Management (Australia) Limited is limited to providing the financial services under its license to wholesale clients only. This marketing material is not to be provided to retail clients.
Acadian Asset Management (UK) Limited is authorized and regulated by the Financial Conduct Authority (‘the FCA’) and is a limited liability company incorporated in England and Wales with company number 05644066. Acadian Asset Management (UK) Limited will only make this material available to Professional Clients and Eligible Counterparties as defined by the FCA under the Markets in Financial Instruments Directive.