LONDON, June 2 (Reuters) - A flagship index of frontier market stocks is likely to struggle to match its previous strong performance after the promotion of its two top scorers, Qatar and the United Arab Emirates.
Youthful populations, high economic growth rates and an expanding middle class have drawn investors to frontier markets in recent years, leading them to significantly outgun emerging and developed markets in terms of returns.
Though smaller and less accessible, these rapidly-changing frontier markets exhibit the characteristics that many bigger emerging markets had a decade or more ago, before growth in economies such as Brazil, Russia, India and China started to become more sluggish.
MSCI’s frontier markets index has returned 21 percent this year in dollar terms, compared with 3.5 percent in emerging markets and 4.6 percent for developed markets.
But a large part of those frontier gains were driven by Qatar and the UAE, each of which has delivered 30-40 percent returns this year. The outperformance is partly due to a recovery in Dubai and strong government spending, but also in anticipation of their well-flagged upgrade to emerging market status this week.
But as they start their new careers as emerging markets, the frontier index will be dominated by two markets - Kuwait and Nigeria - which together will make up 45 percent of the index.
These markets, and the new skew of the index, may not appeal as much to investors.
“Kuwait is hardly a pre-emergent consumer economy with plenty of upside,” said Daniel Broby, a veteran frontier market investor and chief executive of Gemfonds.
“Its weight, a function of listed financials and lack of stock markets in other frontier markets, is the bane of the frontier space.”
Kuwait has returned 15 percent this year in dollar terms, but that is partly down to a steady currency.
Nigeria, struggling with a weak currency and beset by political risk over upcoming elections and the abduction of over 200 schoolgirls by Islamist group Boko Haram, is flat in dollar terms.
High-yielding Nigeria is considered a risky play, while highly-rated Kuwait is seen as a relatively safe frontier investment. Investing in both countries at once therefore doesn’t make much sense, analysts say.
Despite the attention given to frontier markets, analysts see only around $20 billion following this sector, compared with more than $1 trillion for emerging markets.
Frontier investing tends to be the preserve of specialist investors, with passive money - which mirrors the performance of an index - making up less than $1 billion, compared with estimates of around $300 billion for emerging markets.
The index is closely-watched by strategists as a barometer of frontier market sentiment, but the lack of dedicated money following it may limit the impact of the changes.
“Anyone who invests in frontier markets using benchmark-based products is unlikely to fare as well as they would investing in funds managed by dedicated and experienced stockpickers,” said John-Paul Smith, head of emerging equity strategy at Deutsche Bank.
Promotion to a higher index has often led to underperformance, as the promoted markets have already risen ahead of promotion, and tend to be small and easily ignored in their new home.
Investors expect a similar fate to befall Qatar and the UAE.
But this does mean that those countries which now have a higher weighting in the frontier index may draw in more of those specialist investors.
Nigerian stocks rallied 3 percent on Friday ahead of the rejig and rose again on Monday to hit four-month highs. Nigeria now makes up 19 percent of the index, up from 12 percent before the changes.
“It puts Nigeria out there and it’s positive for the market,” said Akinbamidele Akintola, vice president, Africa equity sales at Renaissance Capital, who said there had been increased interest from foreign investors.
Stocks in Kuwait - which will make up 26 percent of the index, compared with 18 percent before - and Morocco , at 6 percent from 4 percent, also rose at the end of last week.
“I‘m still reasonably upbeat on the ‘new Frontier Markets’,” said Andrew Howell in emerging equity sales at Citi, in a client note. “Frankly, I like the index a lot more without UAE and Qatar, and if only you could somehow get Kuwait out of there, it would become a pretty good proxy for some the world’s most dynamic, fast-growing and potentially explosive developing economies.” (Additional reporting by Sujata Rao in London and Chijioke Ohuocha in Lagos; Editing by Toby Chopra)