LONDON, April 16 Life may be about to get even riskier for investors in some of the world's riskiest markets.
Investors could find it harder to use the closely watched MSCI frontiers index to benchmark their performance when it loses major constituents next month.
The upgrade of two large markets, the United Arab Emirates and Qatar, to emerging market status, will cut the number of constituents in the frontier index to 24 and give a hefty weighting to only two - Kuwait and Nigeria.
The decision comes after MSCI frontier markets as a whole have returned 12.5 percent this year in dollar terms, compared with a tiny 0.3 percent rise in emerging stocks and developed markets' 0.1 percent dip.
For GRAPHIC, see link.reuters.com/zyh97s
But those returns incorporate a wide range of performance, from 27 percent growth in Bangladesh to a 9 percent loss in Nigeria. Currency fluctuations may also play a part, with the weakening naira feeding into Nigeria's dollar-based losses, for example.
The UAE posted returns of 35 percent and Qatar made gains of 21 percent.
In the short-term, market players say, investors are likely to diverge further from the benchmark weightings to reflect more closely their views on frontier markets, potentially opening themselves up to underperformance against the index.
"The index becomes even more lopsided, I just do not think it's representative (of the frontier market universe)," said Julie Dickson, equity product manager for emerging market fund Ashmore.
She added that the effect would likely be relatively short-term, however: "Eventually that will encourage MSCI to include more frontier markets, and to upgrade some more of these frontier markets to emerging markets."
UP AND AWAY
The existing MSCI frontiers index includes an eclectic bunch of countries whose economies vary in size and stage of development. It is followed by $5.5 billion in funds, compared with $1.3 trillion for the emerging market index, but is attracting increasing attention due to its strong performance.
Saudi Arabia and Botswana are among countries which could be included in future, investors say, although MSCI says markets need at least two stocks which are relatively easy for foreigners to access before they are eligible.
By equity index providers' definitions, what is key are the market capitalisation of the stock exchange and market accessibility, rather than the size or wealth of the economy.
Investors are already taking positions out of line with the weightings of the MSCI and other frontier indices compiled by S&P, Dow Jones and FTSE. That's because the indices include markets as diverse as Bangladesh, a poor Asian economy, and euro zone member Slovenia, making them tough to follow.
With the departure of UAE and Qatar, Kuwait and Nigeria will together make up nearly 50 percent of the benchmark, analysts say, with Morocco, recently downgraded to frontier status, becoming the third-biggest market.
Highly rated Kuwait is seen as a relatively safe investment, and Nigeria as a more speculative play.
"Risk-on is Nigeria, risk-off is Kuwait," said Maria Gratsova, emerging equity strategist at Citi.
"When markets are going up, it's easier to outperform the benchmark, as Kuwait tends to be more defensive."
Nigeria has attracted attention since the recent rebasing of its GDP to make it Africa's largest economy. But uncertainty over elections in 2015 and the recent suspension of its respected central bank governor have hurt Nigerian stocks.
"You can take an aggressively negative view on Nigeria but you will be running a big risk in reference to the benchmark," said Bill O'Neill, head of UK investment office at UBS Wealth Management.
But frontier market investors are used to taking on more risk, and that includes divergence from an index.
Templeton Emerging Markets Group has $3 billion under management in its frontiers strategy.
"The MSCI Frontier Markets Index provides a handy benchmark for investors...but (is) not something we strictly adhere to when making investment decisions for our portfolios," Templeton Emerging Markets Group chairman Mark Mobius said in a blog. (Additional reporting by Natsuko Waki)