We Know the Part of Frontier and Emerging Markets Risk that Matters

A well-diversified investment portfolio includes a portion of assets dedicated to Emerging Markets—those countries featuring large and growing populations striving to rise out of poverty and form a consumer class driven by individuals’ aspirations and ambition.   

Alongside the promise, however, is a myriad of risks threading through each country’s unique government structure, economic engine, legal system, and trade preferences. The challenges are complex, especially when Frontier Market countries are added to the mix, and one country’s most pressing issues may not cross the border into neighboring nations. Even more problematically, they may not even endure from one ruling party to the next.  

Amid such on-the-ground disparities, many Frontier and Emerging Markets (FEM) investors conclude that representative index investments will level the landscape, with returns from seemingly stronger countries compensating for even sharp drop-offs in others.  

We disagree.  

At Consilium, we contend that index risk—the collective uncertainty that stems from passively tracking a heterogeneous collection of countries that are assigned weightings based on purely quantitative calculations—looms larger than country- and company-level risks.

And without an active approach to FEM investing, investors are exposing themselves to situations that will invariably saddle them with avoidable setbacks and divert them from potential gains.   

Some Markets are Best Avoided  

The reality of a worldwide investing mandate is that some countries are un-investible.   

It’s not an indictment of the country’s people, cultures, or successful businesses, but macro conditions in many countries are poor or deteriorating. Furthermore, such developments can sometimes sneak up on investors and accelerate rapidly, leading to the point where previously invested cash cannot be repatriated out of the country through traditional channels.  

Yet, much, if not most, of the investing world is dominated by indexes and the relative performance of a fund or strategy compared to their relevant benchmark index. The rise of indexation has been strengthened over time by the increasing allocations to ETFs that seek to mimic an index.  

Flows into such funds favor the constituents of the index, even if fundamentals are faltering. Or, in the case of a multi-country FEM strategy, flows are directed into nations where all signs are pointing to a burgeoning crisis, but following an index means adhering to country allocations.  

Consider Argentina in the late 1990s. Emerging Market indexes failed to reflect the country’s economic erosion, which forced interest rates higher. Therefore, increasingly risky new bond issues and other securities had to be purchased by Emerging Market managers who couldn’t stray from index weightings. When the country defaulted in 2001, it owed $100 billion and the economy collapsed, leaving investors worldwide with large losses.  

When 0% is the Right Call  

Given the abundance of increasingly bad economic policy sets with no sense of recovery around the world today, it has become more important than ever to make critical decisions about country allocations in FEM investments. Even down to zero when warranted.  

Regardless of what some index says.   

Just as critically, in countries that have good, or at least improving, policy sets, investors should strongly consider increasing their exposure beyond the index weighting, assuming there are company stories that warrant it.   

Without such active attention to day-to-day conditions, investors will struggle to overcome index risk. Especially in the FEM universe, where policy disparities—and likely eventual performance disparities—between index constituents are steadily increasing.  

Curiously, ETF giant Blackrock recently announced that it would no longer direct investor funds into select Frontier Market countries due to struggles to get money out of them. Having watched the firm’s investment choices over the past few years from afar, we can’t help but wonder if this is a case of a case of closing the barn door after the cart has left. Especially as the fund had seen significant inflows in the period leading up to the announcement.   

Nonetheless, it’s certainly validating to see one of our longtime core tenets implemented by an industry leader, although we’re intrigued to see how the execution plays out.    

A More Thoughtful Way to Proceed  

For all of the consternation swirling around active asset managers, the value they add over passive index investments within Frontier and Emerging Markets largely boils down to risk.   

What risk is mitigated by an “aggressive” manager who opts to invest in a country with a minimal presence in the index over a country with a large share of the index? What losses may be avoided by a manager who considers the decision not to invest just as important as the decision to invest?   

By eliminating the ties to a Frontier or Emerging Markets index, you’re reducing overall portfolio risk by narrowing the scope to individual countries and specific stocks. Such focus and a discriminating eye are where a good FEM asset class manager will add risk-adjusted value to one of the most fascinating slices of the investment portfolio.