Sunday, 27 April 2008

Investing in Frontier Markets

In his famous book A Random Walk Down Wall Street, Malkiel claims that the market is so efficient that it is impossible for anyone to know which stocks will go up (tell that to Warren Buffet). Malkiel claims that a monkey throwing darts at a list of stocks on a broadsheet will outperform the best fund managers from Wall Street. Recently, Malkiel has been going around saying that a better way to put it is that an investor should put a "blanket" (his words) over the list of stocks and purchase everything.

Vanguard founder John Bogle advocates the same thing, and today about 20 per cent of investors engage in index investing. The problem is that Bogle used to claim that individuals should only invest in an index fund that tracks the S&P500. Foreign diversification was not necessary because U.S. companies do business in foreign countries anyway. Suppose they did. Couldn't we argue that ExxonMobil does business with hundreds of other firms in America, and so therefore we don't need to buy stocks in other companies in America? Anyway, Bogle said all this when the American market was booming. Recently, however, with American markets stagnant in the wake of the property collapse, Bogle now claims that indeed you should diversify internationally. He claims, however, that you should only put 20 per cent of your portfolio in non-U.S. index funds because of costs of investing in foreign countries. Some people also claim that investing too much outside the country of residence can increase currency risk too much.

The idea of having a huge bias towards the home country seems to goes against the principle of indexing in the first place. If we throw a blanket over American stocks and buy and hold them all, then why shouldn't we throw a blanket over global stocks and buy everything in the world?

Some people try to do this. I know of someone who holds only two ETFs on the ASX: IOO, which tracks the top 100 multinationals; and IEM, which tracks the MSCI Emerging Markets Index. Through these two ETFs he gets the developing countries in IOO and the emerging countries with IEM. However, this doesn't cover everything. He is missing out on frontier markets. Standards and Poors has an index that tracks frontier markets called the S&P Frontier Markets Index. They describe frontier markets as follows: "The S&P/IFC Global Frontier Markets cover the lesser developed markets even by emerging market standards." There are 24 countries in this index.

Then there are those countries that have no stock market at all, e.g. Cambodia. There are rumors that a stock market will be built in Cambodia soon by some Koreans, but I am not too certain. If that is the case, Cambodia will likely become a frontier market. At the moment though the only way I think people can invest there is through microloan systems like MyC4 (for profit), Ebay's Microplace (for small profit and for Americans only), and Kiva (for charity). At these sites you have to shop around and read stories about those you want to lend money to. It would be nice and convenient if there were a microcredit ETF available that provided decent growth and dividends. Microloans at Kiva are not actually stock exchanges in that the investments are unlisted, not listed.

As a rough rule, the less developed the country is, the higher the potential returns are but the greater risk there is. Today's emerging like Russia, Brazil, China, and India have growth considerably and have produced immense (e.g. 40 per cent per year) wealth for those invested there. However, with more and more money pouring into these countries, the potential for returns may diminish. The stock market of China may be overvalued, depending on who you ask. It is worth then looking at the next emerging markets, which is today's frontier markets.

Should you invest in frontier markets? The way I see it, whether you want to invest in frontier markets depends on your risk tolerance. It is exactly the same as leverage (borrowing to invest). If you borrow to invest, you might make more if the markets go up. However, if the markets go down, you lose a lot more. The degree of gearing or levering an individual chooses will depend on his or her tolerance for risk. Similar thing applies for investing in less developed countries. If you have low tolerance for risk, stick with America and EAFE countries (Europe, Australia, and Far East).

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