The inclusion of frontier markets in a portfolio : an evaluation

Abstract

This empirical study investigates the investment opportunities that frontier markets may offer to investors. Frontier markets, unlike developed and emerging markets, remains an area that is relatively unexplored in literature. This study aims to offer insight as to whether including frontier markets in a portfolio has proved to offer performance and diversification benefits to investors, in comparison to developed and emerging markets. This study employs analysis of a quantitative nature, exploring the risk-adjusted returns of frontier markets over the period 2002 to 2016, by employing metrics such as the Sharpe ratio, the Treynor ratio and also Jensen’s Alpha, as well as utilising cross-market correlations to measure diversification. Moreover, this study also explores the benefits over three separate sub-periods; consisting of pre-crisis period (2002-2007), crisis period (2007-2009) and post-crisis period (2009-2016). In turn offering further comprehension as to whether frontier markets may also be considered short-term investments and examining in detail frontier markets’ reaction to different types of market trends. In this study, the S&P 500, the Eurostoxx 50 and the Nikkei 225 indices represent developed markets, while the MSCI FM and MSCI EM represent the frontier and emerging markets respectively, and finally the MSCI FM Africa index represents a specific frontier market country. Furthermore, the latter part of the study analyses frontier markets within two different types of portfolios; a risk parity portfolio and an equally weighted portfolio, where the FM indices are included and excluded respectively. The findings of the study reveal that frontier markets have experienced superior risk-adjusted performance over both the long-term and short term periods; both individually and within a portfolio. Frontier markets exhibit relatively low beta coefficients and also volatility, throughout all the periods analysed. On the other hand, the research also finds that investments in frontier markets during a crisis have led to enhanced losses, which may be attributable to large capital flight experienced during the crisis. We also find that frontier markets exhibit low correlations with developed markets, emerging markets and frontier markets themselves, proposing to be useful tools of diversification. Nonetheless, during and after the crisis, correlations increased substantially, indicating increased integration. When analysing frontier markets within a portfolio, we find that frontier markets decrease volatility in all the periods analysed, which subsequently lead to higher Sharpe ratios. The risk parity portfolio was able to produce greater Sharpe ratios in all periods than the equally weighted portfolio, mainly due to the lower volatility and higher returns experienced by frontier markets. Thus, the study empirically shows that frontier markets exhibit un-paralleled investor benefits when included within a portfolio, which essentially offers valuable opinion to the existing literature on frontier markets.