Indices don’t deliver growth on the frontiers

WITH average pension fund exposure to emerging markets (EM) languishing around 3-8 per cent, portfolio rebalancing should be a top priority. But beyond the impressive returns offered by developing economy exposure, there is a faster-growing subset of this asset class to consider: “frontier” markets – those countries with high potential but less developed investment environments than most EMs (see chart).

Unfortunately, for fans of index-tracking, the options are thin. Most of the UK’s biggest providers of exchange-traded products are more focused on expanding their conventional EM range. Deutsche Bank does offer exposure in the form of a db x-tracker, or exchange-traded fund (ETF), that tracks the S&P Select Frontier index, an index developed in order to represent liquid and tradable equities in markets that are traditionally hard to access.

The fund currently holds around $38m in assets under management (AUM), up from $10m at the beginning of the year. The problem is that as a high-risk, high-reward supplement to a developed equity or bond-focused portfolio, this particular index does not actually capture most frontier market growth. 28 per cent of the equities represented are Kuwaiti companies.

Deutsche’s Manooj Mistry says: “The high percentage of Kuwaiti companies reflects that they’re more liquid. There will be a bias towards companies with a decent-size market cap that are relatively liquid.” One alternative is to look for ETFs that target particular countries, like Deutsche’s FTSE Vietnam Index ETF, currently at $188m AUM. But even in country-specific funds, the most liquid companies are often not those that will grow the most. As Mistry admits: “If people want more granularity or specific exposure, they’d have to look elsewhere.”

Franklin Templeton’s Mark Mobius puts it more stridently: “Frontier indices are hopeless. They don’t reflect the real world out there.” In his view, index tracking is an unsuitable tool for targeting this high-return subset of EM growth.

This speaks to a broader problem in using automated trading tools like index-tracking to invest in less developed markets. The underlying philosophy of index fund investment is that investors are better off capturing the overall growth of the market than paying higher fees to stock-pick. Many investors assume that most stocks will return to the average growth rate of the market rather than consistently outperforming their peers. So even if an active fund outperforms one year, chances are it will under-perform the next.

But in order for this to work, the universe of investable companies has to be large enough. The high average growth of a developing country is not the same thing as the growth of its stock market.

For fans of passive investment, this means that examining the content of the index being tracked is crucial to ensure that you are actually getting the benefit of your target asset class’s growth.