Correlation and Non-Correlation in Frontier Markets - dummies

Correlation and Non-Correlation in Frontier Markets

By Gavin Graham, Al Emid

When researching frontier market investing, you periodically hear references to correlation and non-correlation.

  • Correlation is the relationship two different assets have to each other. If they have a correlation of 1.0, they are regarded as being perfectly correlated and they will always move in the same direction at the same time. If the correlation is 0.0, then there is no correlation between the two assets and they will never move in the same direction at the same time. That demonstrates the principle of non-correlation.

  • Negative correlation means that one asset moves in the opposite direction from the other, which effectively reduces volatility to zero.

This is what hedge funds were originally set up to attempt to do: Find assets that would offset the movement of other assets. For example, if you invested in automobile stocks but were concerned about the cyclical nature of the industry, you could buy (go long) one company, say General Motors, and sell (go short) a less attractive company in the same industry, say Ford Motor Company. Then you would have no net exposure to the industry, but you hope your long position goes up and your short position goes down, and you still make money.

Obviously, many of the same underlying economic factors that affect frontier markets also affect emerging markets, particularly because they are both comprised of generally less wealthy developing economies. However, because frontier markets have less developed financial markets and are not as liquid or easily investible, foreign investors have much smaller exposure to them. Therefore, when foreign capital starts to flow out of emerging markets, as has happened in 2013–2014, frontier markets are much less exposed and perform more profitably.

Similarly, when foreign capital was flowing into emerging markets between 2009 and 2011, they outperformed frontier markets, rising 17.4% per annum against –0.3% per annum.

This non-correlation makes it important to include some frontier markets with your emerging markets exposure and to own both asset classes, because there will be periods when one of them outperforms the other one. However, this equation does not affect the underlying reason for investing in frontier markets. As less developed economies, they are in the same situation as the major emerging markets were 15 to 20 years ago. Assuming that they follow the same successful economic policies, they should see their economies and stock markets do as well as emerging markets have done over the last decade. After all, one of the reasons that foreign investors have put so much money into emerging markets is that they have delivered in terms of economic performance and stock market returns. In the last ten years ending mid February 2014, the emerging markets index have returned 7% per annum in U.S. dollars against 4.3% per annum, despite their 11.2% fall from 2013 to 2014.