Investment Commentary – January 2013

The Next “Frontier” in Diversification?

Diversification might be the one “free lunch” when it comes to investing. Markets that move in different directions allow a downturn in one to be offset by a gain in another, resulting in potentially higher returns and lower risks over the long term. With anemic growth rates in the developed world, the largest emerging markets of Brazil, Russia, India and China (BRIC) have picked up the slack. Their steady advance has been a boon to both economic development and investment performance alike, driving global GDP and returns higher since the recovery began.
However, as globalization blurs regional boundaries, some have argued that the diversification benefits of the BRIC countries are diminishing. It is being pointed out that at a time when investors truly needed diversification – during recent periods characterized by volatile price swings and mounting uncertainty – returns in the developed and emerging markets actually converged. Increased interdependence has also magnified the risk of financial contagion, where a downturn in one region can have ripple effects throughout the world. Although developing at a considerable pace, it is unlikely that the BRIC economies can remain completely immune to slow growth in the developed world.
Against this backdrop, equities in the frontier markets are garnering an increasing amount of interest. Still in its infancy, this asset class is comprised of stocks in countries described as the “up-and-coming emerging markets”. The difference between emerging and frontier markets is that the latter are at a much earlier stage of economic and financial market development. They include Middle Eastern oil states, former Eastern European Bloc countries, as well as the low/middle income nations in Africa and Latin America. The main appeal of frontier market equities is that they are not only less correlated with each other, they have also been the least correlated with mainstream equity markets.

As a result, recent studies show that in a portfolio context this asset class is not as risky as it seems. While it is true that there are a myriad of political, economic and investment risks facing frontier markets, the “blow-up” risk of any single country can be mitigated through diversification. Additionally, frontier market returns are mainly driven by localized factors, which means they have been relatively less affected by global macroeconomic events. This is demonstrated in the chart above, which shows that a diversified portfolio of frontier market equities was less volatile than the broader emerging markets index over the past five years.

As some of you may remember from our blog post last year, TEIC is always on the lookout for suitable new investment alternatives. As an asset class, frontier market equities have some favourable attributes; however, there are caveats. These investments require a long-term view, with the next phase of their development expected to unfold over a decade or more. This is evidenced by the fact that, although they have been less volatile, to this point the returns of frontier market equities have lagged the more mature emerging markets. In addition, brief track records and high fees make practical implementation somewhat limited. Nonetheless, we continue to monitor this segment for suitable investment options. As frontier markets advance and globalization expands, this asset class could eventually become a viable option for our clients, complementing exposure to BRIC equities in a well-diversified global portfolio.
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These articles are for general informational purposes only. Please obtain professional advice before taking any action based on this information. No endorsement or approval of any third parties or their advice, information, products or services should be implied by any references to third parties contained in any article. Trademarks cited in these articles are the respective properties of their owners.

5 replies
  1. Jim Tremain says:

    At the age of 81, diversification within a portfolio means a stable political situation, healthy ROE, good dividend history, and I can find that in Canada. Banks, plus utilities, plus food, plus oil and gas, and maybe a mine is all I need; right here at home.

    I feel your commentary is trying to please your younger clients and assure them of opportunity in the Frontier & Emerging markets. Yes, that is true. But I sense excessive emphasis on your part on this strategy.

    Jim

    Reply
    • T.E. Wealth says:

      Thanks very much for your comments. Our commentary is certainly not intended to please any one demographic, whether clients or not. Rather, our intent here is to share some of our research efforts and provide information and education to our audience. We did not intend to create the impression that we were emphasizing this strategy. Our investment commentaries are for information purposes only and are by no means recommendations.
      We do however recommend that portfolios be diversified beyond Canada as our market has 80% exposure to 3 sectors being banks, energy and materials. Our public market has very little exposure to industries such as information technology, consumer goods, pharmaceuticals and industrial products which are better represented in foreign equity markets.

      Reply
  2. David Corriveau says:

    This investment commentary provides a very interesting perspective: risk mitigation through less correlated, smaller tranche diversification. Top this off by investing in regions which carry basic necessities such as energy, water and food supply….I like it.

    Reply
  3. David Little says:

    Like others, I too notice that geographical diversification has had limited effectiveness; one major country’s problems quickly influence others, notably those that export to the problem country.

    I understand that the Canadian market is heavily weighted to a few sectors, but Canadian investors do not have to ‘buy’ that distribution. Having ‘diversified’ into the US market several years ago, my gains in US dollars have been reduced to almost nothing due to exchange movements. And my investments in the rest of the world have performed abysmally – indeed one would have to have been extraordinarily lucky in one’s choice of instruments do have made any significant gain over the last decade in AEFE markets.

    Even if one invests in a broad Canadian market indexed ETF, there is nothing to stop individual investors from making supplemental investments in sectors of interest (like utilities for example) and avoiding financials, energy and materials, well covered in the index investment, and thus offsetting the inherent sectoral bias in the TSE. Investing overseas is not the only solution, and may not be the best one.

    Reply

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