What great frontier story, from the Wild West to outer space, ever featured a passive hero?

Answer: none.

The same can be said of a frontier market investment strategy. When it comes to frontier markets, active, engaged, and quick to react is the way to go.

Why? Because, as I’ve discussed in my book, a frontier market doesn’t behave in the same way as a developed market.

Pitfalls of Passive Investing

Passive investment management is investing on autopilot. You buy either the underlying stocks that compose a market index or a fund that mirrors the index. The argument for passive investing is that markets are efficient, and trying to select individual stocks to beat the markets return is a waste of time and money. Proponents of passive investing point to numerous studies that show (mainly for U.S. equity managers) that the average active manager underperforms the market after fees.

This may be true, but outside the heavily researched and very liquid developed markets, passive investing encounters two major pitfalls: indices do not accurately reflect the composition of the universe they purport to represent; and they completely miss many attractive investments in under-researched, misunderstood, and hard-to-access countries and companies. Such opportunities can be uncovered only through active management. This has been true in mainstream emerging markets for the past two decades, and it is even truer in frontier markets today.

For example, lets look at the granddaddy of emerging market indices: The MSCI Emerging Markets Index.

There were ten countries in the original 1988 index. Four—Argentina, Greece, Jordan, and Portugal—are no longer in the index, but the total is now up to 24 countries. In terms of weighting, the remaining original six countries today constitute less than 20 percent of the total index; the 18 new countries, which include Korea and three of the four BRICs, account for the other 80+ percent.

Clearly, this index undergoes frequent change; but even with continual updates, it cannot always capture the emerging universe in a timely manner, and it mostly looks through a rearview mirror. Index investing can therefore force you to buy past winners regardless of their future prospects.

Frontier benchmarks face similar limitations. MSCI launched its Frontier Markets Index in late 2007 with 19 countries. By the end of 2016, five countries (including two countries representing a combined 30 percent of the index) were dropped and nine new countries added. On June 1 of this year, Pakistan—9 percent of the FM index—is being moved to the EM index—with a weighting of just 0.2 percent. And currently under review, Argentina (19 percent of the FM index today) and Nigeria (19 percent of the index just three years ago) may be dropped in the coming year.

This flux in the composition of indices underscores the first pitfall of passive investing in developing markets: Indices do not reflect the reality of the universes they purport to represent.

The second pitfall of passive investing is that it gives investors no freedom of choice. (For specific information on ETFs, please see chapter 7 of my book, Frontier Investor.) While passive investors are stuck with the index constituents, active investors can use a combined top-down and bottom-up approach. Active investors, therefore, can pick better companies from those countries already in an index and also expand their universe to encompass countries with strong and improving fundamentals that are implementing structural reforms.

For example, for many years one of the largest country exposures in our frontier market funds was Saudi Arabia, which is not even part of the benchmark frontier index. It is, however, one of the deepest and most liquid markets in my frontier universe, and helped us generate market-beating returns that a passive plan would never have produced.

2017-05-22T23:05:26+00:00 May 22nd, 2017|Blog|0 Comments

Leave A Comment