Though emerging markets have started gaining prominence in equity portfolios – especially this year due to their performance – frontier markets are still considered a bridge too far by many.
If an investor were to allocate equity exposure across home, emerging and frontier markets via the largest ETFs tracking these markets in the proportion of their total assets sizes, the following graph would be the result.
Even if the decision of allocation were made only between emerging and frontier markets based on the proportion of asset sizes of the largest ETFs tracking these markets (EEM and FRN), the latter would form only 1% of the exposure.
However, if one was particularly bullish on frontier markets, which combination of funds would provide the best diversification?
There are three broad-based ETFs available for investing in frontier markets, listed on the basis of their asset size from largest to smallest:
- iShares MSCI Frontier 100 ETF (FM)
- Guggenheim Frontier Markets ETF (FRN)
- Global X Next Emerging & Frontier ETF (EMFM)
In the previous article of this series, we had looked at the diversification relationship between country-specific frontier markets ETFs, Global X MSCI Nigeria ETF (NGE), Global X MSCI Argentina ETF (ARGT) and VanEck Vectors Vietnam ETF (VNM) and the FRN. These are the only three exchange traded funds traded on US exchanges which are dedicated to specific countries.
But what is the relationship between these three as relates to diversification?
Correlation matrix analysis
The table below displays the correlation coefficient between combinations of two of the aforementioned three country-specific funds.
The matrix was created based on returns data for the past three years.
For statistical significance, the p-test was applied to the data and the relationship between the returns of all four funds among themselves was found to be significant. This means that there is a substantial possibility that their performance has less to do with mere chance.
The table shows that the lowest positive correlation is between VNM and NGE closely followed by ARGT and NGE. On the other hand, ARGT and VNM have a much higher degree of correlation between their returns.
Diversification benefits are highest when the correlation between asset classes or instruments being compared is negative and they increase as the coefficient moves closer to its maximum value of -1.
However, since negative correlation between instruments is hard to find, low positive correlation provides the best way for portfolio diversification.
However, it is important to note that this is subject to a positive view on the instruments in question. For instance, at this juncture, Vietnamese equities may be an interesting proposition, and if one has a positive view on Nigerian equities as well, the VNM and NGE combined may not only be a good addition to a portfolio but also a good diversifier.
In such a scenario, if a portfolio already carries exposure to one of the three broad-based frontier market ETFs listed above, then adding ARGT would not result in efficient diversification.