Unfortunately, for those trying to get their head around emerging and frontier markets, there's no universally embraced definition of what constitutes each.
Classification systems vary widely between indexers and benchmarks.
Emma Wall, senior international editor for Morningstar, explains.
Emerging Market, or EM
There are currently 24 EMs as identified by indexer MSCI: Brazil, Chile, China, Colombia, Czech Republic, Egypt, Greece, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Pakistan, Peru, Philippines, Poland, Russia, Qatar, South Africa, Taiwan, Thailand, Turkey and the United Arab Emirates.
Twenty-nine years ago, there were just 10 countries in this sector – representing just 1% of the total value of shares available to private investors. Today those 24 nations represent nearly 30% of the investable market. In 2003, EMS made up 24% cent of global, GDP. According the International Monetary Fund they make up 59.75% today.
Morningstar data relies on the World Bank's methodology for classifying markets as developed or developing. To arrive at a country's classification, World Bank focuses on a country's economy and, in particular, its relative level of wealth per capita. Countries with high levels of per capita income are classified as developed.
Meanwhile those countries with low, middle, and upper-middle incomes per capita, relative to incomes in other countries around the globe, are classed as developing, or emerging. Countries with even lower levels of income per capita are deemed frontier markets. These tend to have more volatile, less diverse stock markets and the companies have poorer levels of corporate governance.
Indexer MSCI examines each country’s economic development, size, liquidity and market accessibility in order to be classified in a given investment universe. If a country is awarded “emerging market” status it means that both active and passive funds which use the MSCI Emerging Markets index as a benchmark can invest in companies listed in that country – resulting in significant foreign investment.
In June 2013, MSCI announced plans to upgrade both Qatar and the UAE to emerging market status. At the time HSBC estimated inclusion in MSCI’s Emerging Market Index could attract $800 million of new inflows into the two countries’ markets as more risk-averse investors start to consider them. Similarly when MSCI downgraded Greece from developed market status to emerging market status later that year it triggered a slew of trades.
Just last month, MSCI added China A shares – that is those listed on the mainland, rather than Hong Kong – into its emerging market indices, which passive funds tracking this index re-balanced their portfolios to include A shares too. Inclusion in a globally recognised, and tracked, index has a duel impact; the shares themselves rise in value with demand, and investors benefit from greater portfolio diversification and more investment opportunities.
Frontier Market
Frontier markets are countries that because of demographics, development, politics and liquidity are considered less mature than EMs.
There are 29 countries currently considered frontier markets by indexer MSCI. These are Argentina, Bahrain, Bangladesh, Burkina Faso, Benin, Croatia, Estonia, Guinea-Bissau, Ivory Coast, Jordan, Kenya, Kuwait, Lebanon, Lithuania, Kazakhstan, Mauritius, Mali, Morocco, Niger, Nigeria, Oman, Romania, Serbia, Senegal, Slovenia, Sri Lanka, Togo, Tunisia and Vietnam.
MSCI examines each country's economic development, size, liquidity and market accessibility in order to be classified in a given investment universe. The World Bank focuses on a country's economy and, in particular, its relative level of wealth per capita. Countries with high levels of per capita income are classified as developed. Meanwhile, those countries with low, middle, and upper-middle incomes per capita, relative to incomes in other countries around the globe, are classed as developing, or emerging.
Countries with even lower levels of income per capita are deemed frontier markets. These tend to have more volatile, less diverse stock markets and the companies have poorer levels of shareholder and corporate governance.
Many of the Middle Eastern stock markets for example are dominated by oil-related stocks, while the Argentinian equity market is equally commodity heavy.
The lack of transparency and information available to investors in frontier markets can mean a wide disparity between a company's value and potential for growth and its current share price. This can result in considerable returns for investors. Similarly, because it can be difficult for foreign investors to access these regions, you can make significant losses.
The macro backdrop to frontier markets can be more uncertain, with many regions suffering from civil unrest or engaged in war. These factors are unpredictable and can cause even high-quality stocks to underperform. While the potential rewards for investing in frontier markets are much higher than those in developed markets, so too are the risks.
