Frontier markets down? Blame the index

The famous Sri Lankan budget taxi, a three wheeler, drives through traffic in Colombo
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Frontier markets tumbled this year, but don't point the finger at the usual suspects, such as weak currencies or oil, investors said. Instead, blame the benchmark index.

Although frontier markets have long been billed as plays on domestic economic growth that is uncorrelated to global markets, they've tracked sharp declines in emerging markets amid huge fund outflows this year. The benchmark MSCI Frontier Market index is down about 18.2 percent year-to-date, in line with the MSCI Emerging Market index's 16.4 percent drop over the same period.

Frontier markets - those not yet big enough to qualify as emerging - are meant to offer the same opportunity for growth that emerging markets such as China, India and Brazil presented 20 years ago. Economic growth there can be rapid. For example, Vietnam reported last week that its economy grew 6.68 percent in 2015.

But frontier countries often have a lot of political risk; can often be vulnerable to commodity prices, cultural and environmental issues; and typically have very thin capital markets.

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There are 24 countries included in the MSCI Frontier Markets index, ranging from Argentina (a former emerging market) and Nigeria to Kuwait and Kazakhstan. And it's precisely the makeup of the index that's causing it to perform so badly, analysts said.

"Index providers take the biggest, most liquid stocks, mostly financials," said Thomas Hugger, CEO of Asia Frontier Capital, which manages the $15 million AFC Asia Frontier Fund.

In frontier markets, "the big story is the consumer. Consumer stocks are normally small," he said, noting that not only are they not well featured in the index, another particularly important frontier segment - infrastructure - is also absent.

The MSCI Frontier Market index is nearly 54 percent weighted toward financials, with almost 10 percent in the hard-hit energy sector. Consumer discretionary stocks make up less than half a percent.

MSCI declined to directly comment on how well its index represents frontier markets' economies. Many frontier market shares may be excluded by the MSCI methodology, which imposes restrictions including minimum free-float requirements and a minimum proportion of shares still available to foreign investors. MSCI also has the MSCI Frontier Markets 100 index, which is used as the basis for at least one exchange-traded fund (ETF), the MSCI Frontier 100 Index Fund. That index includes the 100 largest components of the "parent" index and is also down around 17 percent this year.

AFC's fund outperformed the index, but was still down 2.1 percent in the January-November period; Hugger said December's performance was likely to be positive.

That fund isn't the only one looking for stock picks outside the benchmark indexes.

"You have to look at frontier markets as an opportunity set to pick the right countries and the right stocks, rather than saying 'will the frontier markets index be up or down?'," said Dominic Bokor-Ingram, co-manager of the Charlemagne Magna New Frontiers fund, which has about 12 million euros ($13.2 million) under management.

The Charlemagne fund totted up a nearly 4 percent return from the beginning of the year through December 17, according to data from Morningstar, making it among the best-performing of the frontier-market funds domiciled in Europe, Asia and Africa. Morningstar doesn't have a frontier category for U.S.-based funds.

Bokor-Ingram said 80 percent of his fund's picks weren't in the MSCI index.

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"We're very focused on domestic growth," he said, noting his fund's biggest overweight was in healthcare, a segment which has a weighting of about 3 percent in the MSCI Frontier Markets index.

"Most of these countries' government-funded healthcare is poor or non-existent. When countries reach a certain wealth level, one of the first things they spend on is healthcare," Bokor-Ingram said.

There's another big factor weighing on frontier markets this year: the plunge in energy and commodity prices. Oil is down as much as 30 percent this year, while among other commodities, iron ore is off as much as 40 percent.

Both Hugger and Bokor-Ingram said their funds largely avoided plays on those sectors.

"We have hardly any investments in commodity or energy stocks," AFC's Hugger said, noting that his fund's country allocation was tilted toward countries such as Sri Lanka and Pakistan, which, as oil importers, benefit from lower energy prices. "Asia frontier markets in general should have a positive impact" from lower energy prices, he said.

Bokor-Ingram's fund is also avoiding energy plays.

"We pretty much don't invest in commodity companies. We're looking to take advantage of economic growth in the local market rather than being a warrant on China," he said.

He added that while about 7 percent of his fund is invested in Kuwait, he's avoiding oil-exporter Nigeria. The fund manager expects the oil rout will eventually force Nigeria to devalue its currency and once that's modeled in to the fund's estimates, stocks there don't appear attractively valued , he explained.

Additionally, he noted that Nigeria's economic growth was slower than its population growth, suggesting a net contraction of the economy. The World Bank estimated Nigeria's population growth rate at 2.7 percent in 2014, while the country's economic growth slowed to around 2.8 percent in the third quarter.

The MSCI Frontier Markets index is weighted 22 percent toward Kuwait and nearly 14 percent toward Nigeria.

- Andrew Osterland contributed to this article.