Final Frontier: Do Fringe Markets Offer Diversification Benefits?

For a long-term buy, hold and rebalance investor, asset class correlations (or rather: the lack thereof) are a key part of success. In recent years, globalized markets appear to have moved more closely in step with one another, so the question becomes: is there something outside of developed and emerging equities that can provide additional correlation advantages, or are these frontiers just more of the same?

Emerging at the Extremes: Holding Each Market Separately

Whether rebalancing with newly-added money or between existing assets, there is much to be said for the historic benefits of slicing and dicing international exposure in developing countries. As William Bernstein points out in his article on Rebalancing Individual National Markets, a “rebalancing benefit is driven by low asset correlations and high asset volatility” – his analysis seems to illustrate an advantage (in tax-advantaged space at least) in less-correlated emerging markets ¬†over more-correlated ‘emerged’ ones. By extension, it is probably reasonable to assume such a benefit exists in frontier markets as well. Still, while many markets are now covered by single-country-specific ETFs, this would require a lot of work, and since other countries have no individual ETF option to date, it might be better to simply wait on such a strategy.

Broader but Regionally-Focused Frontier ETF Options:

So, for many (or most) of us, the prospect of trying to hold each country separately, and the task of rebalancing, just does not fit the ‘lazy’ approach we are looking for. This, in turn, leads to the question: what about frontier market ETFs? Here are some popular options with high-enough trading volume (thus, in turn, liquidity) to warrant consideration – listed by ticker and top five countries of equity holdings:

FRN: Chile, Colombia, Egypt, Argentina, Peru
AFK: South Africa, Egypt, Nigeria, Morocco, UK
GULF: Qatar, Kuwait, UAE, Morocco, Egypt
GUR: Russia, Turkey, Poland, Hungary, Czech

First, FRN (Guggenheim’s frontier market fund) is noticeably quite heavily tied to South American countries. Given their regional links, this may not be sufficiently diversified. Thus, consider the Africa (AFK), the Middle East (GULF) and Eastern Europe (GUR) supplements that might help round out the offerings. Together, a picture emerges that looks a little more promising – regionally-diversified exposure. However, many of the countries listed above are also contained in broad, emerging-market index funds like Vanguard Emerging Markets Index – including Egypt, South Africa, Russia and others. Given the low-cost, low-turnover option that this single provides, it is worth being very sure that further diversification would be of help to a portfolio before locking into such a sliced-and-diced variant for the long haul.

But Are they Really Worth the Effort, Risk and Cost?

As it turns out, there appears to be some benefit, but it is up to the individual investor to decide whether it is sufficient to warrant this handful of extra holdings. In the end, there does not appear to be a huge benefit in terms of correlations – certainly nothing as high as diversification between so-called ‘super-asset classes’, probably not one as large as holding individual national countries or different developed/emerging indexes either. And, of course, there are taxes and expenses – both potentially quite high (or: the latter at least, even in tax-advantaged ROTH, other IRA or 401K retirement-account space). The conclusions are up to you, but seeking frontier market exposure may not really be as great as it sounds in light of the risks and options currently available to individual investors who prefer to use lazy, largely-indexed strategies. And, as the graph shows, some factor (perhaps their frontier exposure, but perhaps costs as well) has also resulted in below-emerging-markets-average returns for far for the short life of each ETF analyzed here.

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