Caravan Capital Management’s recent paper on frontier equity markets makes several salient points.  For starters, in reference to the S&P Frontier BMI Index and the MSCI Frontier Markets Index the fund notes:

“Commodity prices tend to drive corporate earnings indirectly through overall GDP growth, as well as the relative strength of many frontier currencies.  As a result, the returns of the frontier market indices are heavily correlated with crude oil and copper spot price returns. In a regression the individual correlation coefficients between the annualized returns of the MSCI Frontier Index and the annualized spot price returns of West Texas Instrument Crude Oil and London Metals Exchange Copper were 0.51 and 0.32 respectively for the 10 years ending 11/30/2009.  While investing in the frontier markets can provide an indirect hedge against inflation for investors based in the developed world, commodity price fluctuations are also a cause of return volatility.” 

Per liquidity, one of the chief characteristics used to classify stock markets within emerging and frontier economies, the fund writes:

“While over $560 billion of securities traded per month for the emerging markets, only $33.7 billion traded for the frontier markets. However, even this large disparity is deceiving as most of that volume came from the much more liquid Gulf countries. When these countries are removed from the frontiers, total monthly volume decreases substantially to $7.4 billion. More dramatically, the monthly volume of all exotic [i.e. those countries not included by either of the two aforementioned indices] frontier markets was a mere $520 million per month over this period.”

On a per trade basis, this relative lack of flow translates into a per trade cost 5-18x (bp) that of emerging markets, the piece calculates.  Finally, as to expected returns the paper highlights the fact that while the simple average of trailing P/E ratios for members of the MSCI Frontier Index vs. the country members of the MSCI Emerging Markets Index as of 4/30/2010 was 11.8 compared with 14.8 for the latter, “these lower valuations may not be wholly justified by this perception of risk, based on one important observation; many frontier equity markets are still dominated by local market participants who rationally demand higher returns to compensate for the country specific risk they experience. However, from the perspective of global investors, much of this country specific risk should be effectively reduced through diversification within a global portfolio.” 

To that end, against the backdrop of lower volatility, not only do frontier markets exhibit “significantly lower correlations to the developed markets than do the emerging markets,” but even strictly among frontier markets diversification is more easily attainable than it is among emerging countries given that “in the five years ending 4/30/2010, the emerging markets averaged a cross correlation of 0.64, while the standard frontiers averaged 0.28, and the exotic frontiers averaged a mere 0.07.”