Since the launch of Fidelity Frontier Emerging Markets Fund, many clients have asked why its index is the MSCI Frontier Emerging Markets (FEM) Index and not the MSCI Frontier Markets (FM) Index (which covers frontier countries only). It’s a great question, and it’s key to how we aim to construct an attractive investment portfolio of growing frontier market–oriented companies while managing the potential liquidity and corporate governance risks that can arise in some frontier countries.
When we began the frontier fund journey in 2014 with an initial pilot fund, we asked ourselves, “What is the appropriate benchmark?” We initially thought it would be best to use the index of countries classified by MSCI as “frontier” countries. However, there were concerns that the investment universe might have trading liquidity issues, and that the geographic exposure was too geared to the Middle East region.
We did notice, though, that key peers in the industry were using the MSCI FEM Index as an alternative. This index combines all the “frontier” classified countries and the smallest emerging market countries. Its main purpose is to offer a more global investment universe, because it is made up of approximately 50% Asia, 25% Latin America and 25% the EMEA region (Europe, Middle East and Africa), and its constituents have high levels of trading liquidity. This crossover construction also minimizes country volatility when countries “graduate” from frontier to emerging status. We saw this with Pakistan in the past year, when it was granted “emerging” status but still remained in the FEM Index.
The next obvious question is how similar the FEM Index is to the broader emerging markets index. Addressing this issue, Chart 1 highlights the countries in each index and the countries that appear in both the FEM and the MSCI Emerging Markets (EM) Indexes. To quantify further, Chart 2 shows the percentage of overlap between the FEM and EM Indexes; it has averaged about 2% over time, which is quite low.
Chart 1: Countries in the MSCI EM, FM and FEM Indexes
Chart 2: MSCI FEM Index as % of MSCI EM Index
The next point of comparison is how the FM and FEM Indexes perform relative to the broader EM Index.
Chart 3 shows the historical beta of both the FEM and EM Indexes to the broader EM Index.
Chart 3: Rolling 36-month beta of both FEM and FM Indexes to MSCI EM
As the chart shows, the red and blue lines are fairly close in their relationship to the EM Index: that is, both have an approximate 60% correlation with the EM Index. This is positive, in the sense that both indexes are “doing their own thing” relative to the EM Index. This helps advisors create more diversified portfolios.
Chart 3 might also suggest that whether one uses the FEM or FM Index will have minimal impact. But, as seen in Chart 4, if we choose the smaller FM Index universe, the trading liquidity of the FM Index (as measured by average daily trading value, or ADTV) is only 50%–60% the size of that of the bigger FEM Index universe. Liquidity issues are almost always cited by investors as a key risk in frontier exposure, so the broader FEM Index, with its better liquidity, helps mitigate this risk.
Chart 4: ADTV (US$) of FM Index constituents as a % of ADTV for FEM Index constituents
In conclusion, when we use the broader FEM index, we have just a 2% overlap with the EM Index, correlations with broader markets are generally the same, and our liquidity risk is sharply lowered – all of which, taken together, should provide a better investment universe for clients seeking frontier market exposure.
Thanks for reading,
Sources: All charts are from FMR and MSCI.
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