LONDON Low correlations between the world's most esoteric stock markets are enabling many investors in frontier market indices to escape, or at least absorb, the turmoil in the Middle East relatively unscathed.
International debt securities in these countries are proving more prone to contagion, but equity investors are reaping some of the diversification benefits that frontiers promise.
As protests have spread across the Middle East and North Africa, causing the downfall of presidents in Tunisia and Egypt, investors have withdrawn money from the emerging markets universe at large. But they have continued to put more money to work in frontier equity funds in particular.
Data from fund tracker EPFR shows frontier market equity funds have enjoyed 36 straight weeks of inflows, while emerging equity funds lost $7 billion in one week earlier this month.
The MSCI emerging equities index has fallen 4 percent this year, underperforming global stocks, which have risen 4 percent.
But the MSCI frontiers index, which includes markets like Vietnam and Romania, as well as crisis-hit Lebanon, Bahrain and Tunisia, has fallen only 2 percent.
Investors are attracted to frontier economies because they tend to have high growth rates, and will one day grow up and turn into fully-fledged emerging markets.
But their low liquidity reduces the chances that upsets in one market will derail another, investors say.
"If you invest in a frontier fund, your risk is really not that great, because you're holding such disparate markets," said Sven Richter, head of frontier markets at Renaissance Asset Managers.
As the correlation between emerging and developed markets becomes stronger, frontier markets' low correlation with their global peers presents an opportunity for investors wanting to diversify.
Emerging equity correlations with developed stocks over the past 26 weeks was 0.8, versus frontier markets' 0.49, ThomsonReuters data shows. A coefficient of 1 implies perfect correlation.
On top of their low correlation with the global economy, frontier markets show hardly any correlation with each other.
The MSCI Nigeria index's correlation to MSCI Vietnam, for example, is a mere 0.19, and even frontier markets in the same region are hardly correlated at all -- Nigeria's correlation to Kenya is a minimal 0.03.
This means that a lot of volatility in a mixed frontier equity portfolio is simply diversified away.
NOT AT THE TOP
While MSCI's emerging markets index has retraced the better part of its 2008 losses, most frontier markets are still trading well below 2007 highs.
After several setbacks -- notably the 2009 Dubai debt crisis -- some investors are betting 2011 is the year frontier markets begin to catch up.
"Some of these (frontier) markets are now getting into the phase where some of the larger emerging markets were 12 or 18 months ago, which is why investors are starting to look at them again," said Andrea Nannini, manager of the HSBC New Frontiers Fund.
Argentinian stocks, for example, hit a lifetime high last month and Estonian stocks are at their highest in over three years, after Estonia joined the euro zone this year.
Frontier stocks are trading at a 20 percent discount to emerging on historical price-to-book multiples, according to data from Credit Suisse, leaving more room for upside.
Debt markets may suffer more, with any new issuance on hold as investors reassess political risk. It is looking unlikely that African states such as Zambia, Kenya, Tanzania, Uganda and Tunisia can go ahead any time soon with their debut Eurobonds.
Bahrain which had been hoping to issue an international bond in March-April will almost certainly have to postpone the deal.
Nigeria sold a long-awaited debut Eurobond in January for $500 million, following issues from Ghana and Gabon in 2007.
Prices of all these bonds have fallen, but particularly the Ghana and Gabon issues, which have seen yield spreads over U.S. Treasuries widen by as much as 80 basis points over U.S. Treasuries.
Many emerging market investors track benchmark bond indices which include all sovereign debt totaling $500 million or more.
Some have become unnerved, both by the Middle East events, and by the default earlier this month of a $2.3 billion bond issued by the world's top cocoa producer, Ivory Coast.
"Africa-focused funds know all the specific details and are quite aware of the difference between countries," said Samir Gadio, emerging markets strategist at Standard Bank.
"For global investors who bought the bonds as part of the index, the countries look alike."
(Graphics by Scott Barber; Editing by Ron Askew)