ACHIEVING DIVERSIFICATION IN GLOBAL PORTFOLIO THROUGH FRONTIER MARKETS

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2 Int. J. Mgmt Res. & Bus. Strat Prakhar Porwal, 2014 ISSN X Vol. 3, No. 1, January IJMRBS. All Rights Reserved ACHIEVING DIVERSIFICATION IN GLOBAL PORTFOLIO THROUGH FRONTIER MARKETS Prakhar Porwal 1 * *Corresponding Author: Prakhar Porwal p12prakharp@iimidr.ac.in With increasing products in global portfolio and related uncertainties, issue of diversification is becoming more and more important for the investors. Frontier markets have risen up to the challenges of diversification at a point in time, when investors are looking for investing in assets with lower correlations across a broad sector of assets and low volatility in the global market. This paper attempts to understand as to how the characteristics of frontier markets as compared to those of emerging markets and developed markets are helpful in achieving better diversification for the investors in the current global scenario. It shows the risk and return data of various markets in different time periods and their performance in periods of boom and recession. It also shows how the low correlations of frontier markets with different markets will help the global portfolios at a time of global turbulence. The following study uses data published by Morgan Stanley Capital International (MSCI) and Standard and Poor s (S&P) for the frontier, emerging and developed markets and data published by Bloomberg for individual country s index. The issue of independent challenges faced by countries in frontier markets has also been addressed as it forms a key component in the risk of that particular country as reflected in the volatility of each country. Keywords: Global portfolio, Diversification, Frontier markets INTRODUCTION Asset allocation in a portfolio is a very crucial task for any portfolio manager. Over the time, many different models have been designed for the same and still the most efficient model may yet to come. One of the most important model was developed by Professor Harry Markowitz (1952) when he gave the concept of efficient frontier in the Journal of Finance. Due to the growing integration of economies and capital markets across the globe over the last decade, introduction of several asset classes has been made to diversify the global portfolios being created. The investors are always looking out for asset classes with low correlations to benefit from diversification and frontier markets is one such asset type which has shown a high potential for the same. LITERATURE REVIEW Investments in frontier financial markets is playing an important role as investors are always on look 1 Indian Institute of Management, SR 7-118, IIM Indore Campus, PrabandhShikhar, Rau-Pithampur Road,, Indore, Madhya Pradesh. 209

3 out for markets giving better returns for an additional risk component. It has been established by Grubel (1968), Levy and Sarnat (1970), Lessard (1973), Solnik (1974) that substantial gains occur from internationally diversified portfolios. Goetzmann, Li, and Rouwenhorst (2005) have shown that investors are alwayslooking to keep expanding their investment horizon to new and less integrated equity markets to get a better diversified portfolio. Speidell and Krohne (2007) mention diversification benefits to be the key motivation for investors to include frontier markets in their investment portfolios. METHODOLOGY The term frontier market is used for those markets which have lower market capitalization and liquidity than the developed emerging markets. There are two major indices providing the data for frontier markets: Standard & Poor s Frontier Broad Market Index (S&P FM) that uses data from 36 relatively small and illiquid markets and Morgan Stanley Capital International Frontier Markets Index (MSCI FM) that uses data from 26 countries. The performance of frontier markets has been compared with emerging markets and developed markets. The indices used for emerging markets are S&P Emerging Broad Market Index (S&P EM) and MSCI Emerging Market Index (MSCI EM).The indices used for developed markets are S&P Developed Broad Market Index (S&P DM) and MSCI Developed Market Index (MSCI DM). The results obtained from these data are also compared with gold as an asset class. For the analysis, monthly closing data has been taken starting from 30 Nov 2008 to 30 Nov Table 1 shows the volatility of the indices along with that of gold for the given time period. Figure 1 shows the volatility for the S&P indices and Figure 2 shows volatility for the MSCI indices. A study of sector wise contribution to the indices shows that more than 50% of the index is comprised of stocks from financials. It is 52.74% for MSCI FM and 54.5% for S&P FM. When contrasting it with EM indices, it can be seen that Table 1: Volatility of Indices Index Volatility Index Volatility S&P DM 17.54% MSCI DM 17.13% S&P EM 22.38% MSCI EM 22.53% S&P FM 17.62% MSCI FM 18.65% Gold 20.75% Gold 20.75% Figure 1: Volatility for S&P Indices 210

4 Figure 2: Volatility for MSCI Indices financials form about 25% of these indices. Table 2 shows the sector wise allocations in EM and FM indices and the differences. Figures 3 and 4 shows the sector weight for MSCI and S&P indices respectively. The reason for the same is that banks have a better understanding and experience in capital markets and that they require huge amount of capitalto achieve profitability with minimum risk. Low weights to Health Care and Information Table 2: Sector Wise Allocation Sector Weights MSCI FM MSCI EM Difference S&P FM S&P EM Difference Financials 52.74% 25.06% 27.68% 54.50% 27.40% 27.10% Telecommunication Services 14.39% 8.46% 5.93% 7.60% 7.40% 0.20% Consumer Staples 9.16% 8.47% 0.69% 8.80% 9.20% -0.40% Industrials 8.98% 6.74% 2.24% 10.60% 7.10% 3.50% Energy 8.05% 12.71% -4.66% 5.50% 11.20% -5.70% Materials 3.52% 12.02% -8.50% 5.70% 9.70% -4.00% Health Care 1.95% 1.16% 0.79% 1.50% 2.40% -0.90% Utilities 1.15% 3.85% -2.70% 1.70% 3.40% -1.70% Consumer Discretionary 0.05% 7.96% -7.91% 2.60% 8.80% -6.20% Information Technology 0.01% 13.58% % 1.50% 13.40% % Figure 3: Sector Weight for MSCI Indices 211

5 Figure 4: Sector Weight for S&P Indices Technology show nascent stages of development for these economies. A main characteristic of the frontier market that helps investors is the low value of coefficient of correlation with the developed markets, emerging markets and gold. Frontier markets are affected more by country specific risk whereas it is different for emerging markets and developed markets. This lack of integration of frontier markets with the global financial marketshelps the investors to take advantages.table 3 provides the correlations for returns of the frontier markets, emerging markets, developed markets and gold. The low correlations values show the reason as to why frontier markets support diversification. An important point of differentiation between frontier markets and emerging markets is that frontier markets are affected more by country specific risk whereas emerging markets are affected due to each other. This can be observed by grouping the country wise data into different geographies. Table 4 shows the volatility along with the geography of the country. Figure 5 depicts the graphs showing the volatility for the geographies. All the frontier markets behave differently and it is imperative for the investor to look out for interplay of national and global factors to take advantage of these markets. Starting from the financial crisis and recession, it is observed that the European economies were hit hard; some more than the others due to their different fiscal policies and economic patterns Table 3: Correlations for the Returns of Different Markets S&P DM S&P EM S&P FM Gold MSCI DM MSCI EM MSCI FM Gold S&P DM 1 MSCI DM 1 S&P EM MSCI EM S&P FM MSCI FM Gold Gold

6 Table 4: Volatility by Geography Europe Volatility Latin America Volatility Bulgaria 18.24% Argentina 28.77% Croatia 15.13% Jamaica 9.40% Estonia 23.21% Lithuania 22.13% Romania 22.00% Serbia 16.47% Slovenia 17.16% Ukraine 33.32% Sub Saharan Africa Volatility Middle East Volatility Kenya 13.96% Bahrain 9.30% Mauritius 9.93% Jordan 9.44% Morocco 11.21% Kuwait 11.61% Nigeria 19.59% Lebanon 9.08% Oman 12.34% Qatar 15.44% Tunisia 13.00% UAE 23.64% Asia Volatility Bangladesh 31.15% Kazakhstan 24.49% Pakistan 14.94% Sri Lanka 17.79% Vietnam 25.16% pertaining to exports-imports, etc. The Arab Spring is a major force that has affected the Middle East countries while leaving other geographies unaffected. The investors should continuously monitor the political conditions in these countries as they can be a major source of shock to the returns from these countries and accordingly, the weights should be adjusted. Another important global factor is commodities. It is believed by many investors in frontier markets that thesemarkets are highly dependent and correlated to commodityprices which makes this is a key risk factor for this asset class. Some of thefrontier market countries are resource rich and therefore these economies benefit from high commodity prices, but there are many frontier markets countries that are resource poor and are therefore negativelyimpacted. 213

7 Figure 5: Volatility by Geography 214

8 Figure 5 (Cont.) CONCLUSION Frontier markets have been producing higher returns with low volatility than the emerging markets in the period observed. Their low correlations with the developed markets and gold show the level of diversification that they can provide to global portfolios. Each country of frontier market behaves in a different manner. The investor should take into account the factors affecting each of the economy and accordingly modify the portfolio to take advantages of diversification from financial markets. This paper shows the importance of frontier markets as an asset class to help achieve diversification in a global portfolio. There are many aspects that need to be covered but are beyond the scope of this paper. The relationship between the individual country s market size to liquidity and volatility needs to be studied in great detail. The macro economic factors and global factors affecting each country in itself will lead to separate studies. The mean-variance frontier achieved by frontier markets portfolio needs to be compared with other portfolios containing exotic products and their proportion in the portfolio. A limitation to this kind of study is that with time, increasing growth and increasing liquidity changes the profile of the country and therefore, it no longer remains a frontier country; whereas, other under developed countries gain prominence and acquire the status of frontier country. REFERENCES 1. Berger D, Pukthuanthong K and Yang J (2013), Is the Diversification Benefit of Frontier Markets Realizable by Mean- Variance Investors? The Evidence of Investable Funds,The Journal of Portfolio Management, Summer, pp Berger D, Pukthuanthong K and Yang J (2011), International Diversification with Frontier Markets, Journal of Financial Economics, July, pp Longin F and Solnik B (2001), Extreme Correlation of International Equity Markets, The Journal of Finance, April, pp Kohlert D (2011), International Diversification in a Troubled World: Do Frontier Assets Still Improve the Efficient Frontier?, The Journal of Investing, Summer, pp Krohne A and Speidell L (2007), The Case for Frontier Equity Markets, The Journal of Investing, Fall, pp

9 6. Quisenberry C (2010), Frontier Equity Markets: A Primer on the Next Generation of Emerging Markets, The Journal of Wealth Management, Winter, pp Speidell L (2009), Investing in the Unknown and the Unknowable Behavioural Finance in Frontier Markets, Journal of Behavioral Finance, Vol. 10, No. 1, pp

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