Make your money travel: Explore developed, emerging & frontier markets

Diversification can sound pretty dreary, but one way to achieve it is to let your investment portfolio travel the world (ok, only metaphorically). By spreading your eggs across different geographical baskets, you can minimise overall portfolio risk at the same time as gaining access to a range of opportunities, including some niche and exciting ones. Some countries can be accessed directly, while others tend to come in a set. This is our introduction to regional investing.

When you invest in a country-specific fund, things are pretty straight forward. But when you invest in a regional fund, you are effectively leaving it up to the fund manager or index (in the case of a passive fund) to decide how much to invest in a particular country within a specified region.

But you don’t necessarily have to choose one or the other; some investors hold a combination of country-specific and regional funds within their portfolio. For example, you could invest in an emerging market fund whilst also tapping into a specific set of opportunities within China via a dedicated China fund. The key is to make sure that the two funds complement each other and there isn’t too much overlap, unless your intention is to double down on a specific country within that region.

So, what are the key regions you need to know about? Well, you have likely come across the terms “developed markets” and “emerging markets”, but you might not have heard of “frontier markets”. Essentially frontier markets is a collection of countries that are similar to countries in the emerging markets category, but less developed and typically faster (but more unevenly) growing. In this Insight article we delve into the history and characteristics of these different regions, which may help you find your perfect destination.

Where did it all begin?

Some developed markets, which include the likes of the US, the UK and Switzerland, have been open to equity and debt investors for centuries. Whilst markets for equities and bonds first started to emerge in the 14^th century in Italy, France and Germany, the first established stock exchange was created in an open courtyard in Amsterdam in 1611 to allow shareholders in the Dutch East India Company to actively trade their shares.

In the centuries that followed, the model was replicated across other parts of Europe, North America and Australasia. For example, the London Stock Exchange was founded in 1801, while the Philadelphia Stock Exchange (now known as Nasdaq) was the first of its kind in the US, set up in 1790. It was followed by the creation of the New York Stock Exchange two years later. Today, developed markets are home to the world’s most established debt and equity markets, with regulatory bodies in place to ensure they function smoothly.

The history of emerging markets appears to be much shorter in comparison. While Russia is thought to have been the first emerging market to enable the trading of shares at the St Petersburg bourse in 1830, these markets have really only opened up to foreign investors in the past 30-40 years.

In a bid to encourage investment in developing countries like Argentina, Brazil, Chile, Greece and India, the International Finance Corporation (IFC), a World Bank subsidiary, started to track the performance of these markets back in 1980. Analysis revealed promising returns, so a year later Antoine van Agtmael, a director at the IFC, sought to encourage professional investors in the US to invest in a fund for developing countries. The response was positive, but one prospective investor questioned his suggested name – “Third World Equity Fund”. Agtmael spent the weekend deliberating and came up with “emerging markets” as an alternative, a name that is still going strong today. As they say: if it ain’t broke, don’t fix it.

Agtmael’s efforts sparked investment across emerging markets, and the region gained further recognition as an asset class when index provider MSCI launched a dedicated emerging markets index in 1987. At the time it covered just 10 countries and in the 33 years that have followed, emerging markets have experienced dramatic growth and, in some cases, a complete transformation.

Frontier markets represent a sub-sector of emerging markets. The term was coined by the IFC in 1992 to describe a number of smaller countries within its emerging markets database which had lower levels of market capitalisation and liquidity. In 2007, these markets received official recognition when index providers S&P and MSCI launched dedicated frontier markets indices.

Today, the MSCI Emerging & Frontier Markets index ha 53 constituents; 25 emerging markets and 28 frontier market countries.

How to tell what’s what

There isn’t a universal definition for how to classify countries and they vary between index providers, but there are some common aspects they all review. For the purposes of this article though we are going to focus on MSCI’s classifications, one of the best-known index providers. They focus on each country’s economic development, market liquidity, and whether the market functions effectively and is open to foreign investors. You can see the full country list for each region here.

Developed markets: the safer option?

Developed markets are countries with high living standards, well-run stock markets, and high levels of liquidity. The theory goes that this should equate to lower risk, hopefully fewer surprises, and more predictable returns for investors. Nevertheless, that doesn’t make them bullet-proof. Some crises tend to go global, like the financial crisis of 2008, which originated in the US, and the COVID-19 pandemic which began in 2020 and floored global financial markets.

Because of the characteristics of the countries in developed markets, this region tends to be more efficient and active managers in aggregate have historically struggled to outperform the index in developed markets more than in other regions.

MSCI’s current list of developed market countries are:

• Americas: Canada, US
• Europe & Middle East: Austria, Belgium, Denmark, Finland, France, Germany, Ireland, Israel, Italy, Netherlands, Norway, Portugal, Spain, Sweden, Switzerland, United Kingdom
• Pacific: Australia, Hong Kong, Japan, New Zealand, Singapore

Emerging markets: the wild west of growth?

Emerging markets include countries that are at an earlier stage in their economic development than developed markets. These countries tend to exhibit rapid economic growth and a broader range of income per capita: from low- to upper-middle. In many cases, these countries will have a growing middle class, which can create a host of investment opportunities – something that is particularly evident in countries like China and India.

With the prospect of fast economic growth comes the potential for attractive returns. However, investors must be prepared for periods of intense volatility along the way. It is also worth being aware that corporate governance standards tend to be lower compared to in developed markets, which can also impact returns. Because of the numerous challenges in emerging markets, this region tends to be a less efficient market than developed markets, which the active management industry tends to use as an argument for picking an active fund instead of following the index. The argument goes that with more complexity, the value of an expert picking the stars from the dogs is higher.

MSCI’s current list of emerging market countries are*:

• Americas: Brazil, Chile, Colombia, Mexico, Peru
• Europe, Middle East & Africa: Czech Republic, Egypt, Greece, Hungary, Kuwait, Poland, Qatar, Saudi Arabia, South Africa, Turkey, United Arab Emirates
• Asia: China, India, Indonesia, Korea, Malaysia, Philippines, Taiwan, Thailand

The father of emerging market investing

Fund manager Mark Mobius is commonly considered to be the pioneer of emerging markets investing. He started his career in the 1980s with Franklin Templeton and in one of his last blog posts before retiring, he reflected on the numerous challenges he faced during the early days. Strict foreign exchange controls, challenges with market liquidity and lower corporate governance standards were all common hurdles, but fortunately things have become better over the last few decades. Today, a variety of emerging market countries can be accessed directly, opening up some exciting investment opportunities for retail and institutional investors alike.

Frontier markets: not for the faint-hearted

Frontier market countries are considered less mature than emerging market countries due to a number of factors including demographics, economic development and politics. They tend to have lower income per capita in comparison to emerging markets, less liquidity and lower standards of shareholder and corporate governance.

The opportunity, however, is that a number of these countries are expected to exhibit the highest economic growth rates in the world over the coming years. This is due to rapid urbanisation, technological developments, and the increased availability of credit to consumers and companies. For example, countries such as Nigeria, Kenya and Vietnam have experienced rapid growth and progress over the past few years alone.

Another important point is that these regions aren’t static. Countries can be up- or down-graded from one category to another. Over the past 10 to 20 years, there have been many success stories of vibrant and fast-growing countries being upgraded in their classification from frontier to emerging market as a result of significant progress. Kuwait is one of the most recent examples, having been upgraded from a frontier market classification to emerging markets in April 2020. The upgrade reflected improvements in Kuwait’s capital markets infrastructure, and the fact the market has become more accessible to foreign investors. It also reflects the country’s efforts to diversify its economy by encouraging foreign investment and reducing its dependency on oil revenues. Typically, when a country receives an upgrade between regions, billions of dollars of inflows can follow as large institutional investors with lower risk tolerance can start investing in the country. There are also examples of countries being down-graded, such as Pakistan which was reclassified a a frontier market (from an emerging market) in September 2021.

Unsurprisingly, frontier markets aren’t well-covered even by professional investors, which means that there is the potential to uncover some real gems. But patience is key: it will take time, often many years, for the real returns to come through and it will most likely be a bumpy ride to get there. Therefore, those who wish to gain exposure to frontier markets will require a healthy risk appetite, a long time horizon and some good old-fashioned nerves of steel. With this in mind, it is usually sensible to have a small allocation to frontier markets as part of a broader, diversified, portfolio.

MSCI’s current list of frontier market countries are*:

• Europe & Commonwealth of Independent States: Croatia, Estonia, Lithuania, Kazakhstan, Romania, Serbia, Slovenia
• Africa: Kenya, Mauritius, Morocco, Nigeria, Tunisia, West African Economic and Monetary Union (made up of Benin, Burkina Faso, Ivory Coast, Guinea-Bissau, Mali, Niger, Senegal and Togo)
• Middle East: Bahrain, Jordan, Oman
• Asia: Pakistan, Bangladesh, Sri Lanka, Vietnam

Can I invest sustainably everywhere?

For those who wish to invest in line with environmental, social and governance (ESG) criteria, emerging and frontier markets can pose a challenge. This is because most sustainable funds focus on themes like climate change and workers’ rights, which aren’t necessarily at the top of the agenda for many of the companies operating in these regions. Many of the countries in emerging and frontier markets are experiencing rapid economic growth, often at the expense of the environment – and this can pose a real dilemma for investors, as we discussed in our Insight article on Impact funds. Company reporting represents another challenge, with annual reports and other statements often lacking detailed information.

But things are changing, and the number of sustainable emerging market funds is growing. The options are significantly fewer in frontier markets, but that is also in the context of a much smaller set of frontier funds in general. Having said that, there are some asset managers out there paving the way. For example, Swedish asset manager Tundra Fonder was one of the first to launch a dedicated sustainable frontier markets equity fund back in 2015. Their process includes developing close relationships with the companies they invest in to help them to work towards a sustainable future. They only invest in companies that are prepared to take responsibility for the impact they have on the environment, their society and their employees. Unfortunately, these funds are not (yet) available to UK retail investors, but given the growing trend of sustainable investing, it probably won’t be long until we see others like it pop up.

What about the returns?

When it comes to the potential returns on offer it is important to remember that there can be a lot of variation between individual countries within each region. For example, according to data from JPMorgan the largest developed equity market, the US, recorded an annualised return of 8.8% over the 15 years to the end of December 2022. But global developed markets, excluding the US, delivered an average return of 2.0% per annum over the same period. Europe, excluding the UK, was slightly higher at 2.4%, and the UK delivered only 1.4%. Returns also vary between asset classes. For example, between 2008 and 2022, the US investment-grade fixed income market in aggregate delivered an annualised return of 2.7% while REITs (as measured by the NAREIT Equity Index) returned 6.6% per annum. All performance figures from JPMorgan Asset Management.

Emerging markets, by comparison returned only 1% per annum on average over the last 15 years. But like in developed markets, individual country returns differ. China recorded an annualised return of 0.6% over the period and India 2.4%. Brazil delivered 2.1%, and Korea 1.6%. As with all emerging market investing, currency plays a big part. As an example, dollar-denominated emerging market bonds returned 6.9% per annum between 2006 and 2020, compared to 5.1% in local currency same period. All performance figures from JPMorgan Asset Management.

There are many different ways to diversify your portfolio and spreading it across the world is just one of them. When deciding what proportion to invest in each region, or country, you first have to figure out your appetite for risk versus reward, as well as your time horizon. The more time you have on your side, the more you can afford to allocate to emerging and frontier markets, which have greater potential to experience more long-term growth than developed markets, but also tend to come with more volatility in the short term. But as the above return figures have shown, sometimes it is less about picking the “right” overall region, and more about the specific countries.

Whichever way you choose, investing can be a great way to not only access, but also help fuel development and change in some of the world’s most exciting countries today. Countries that will grow to be the developed markets of the future. And what is investing about, if not the future.

Date of publication: 6th January 2021

Date of revisions: 28th February 2023