Frontier markets provide better diversification than usual EM

VNM corrEnlarge GraphVietnam is considered a frontier market, which means that while it has an investable market, it is much smaller and less developed than the more mature emerging markets. Aside from lower liquidity, investing in frontier markets usually faces other challenges, such as foreign ownership limits or reduced market hours (prior to 2002 the Ho Chi Minh Stock Exchange, HOSE, in Vietnam traded only on alternate days).

Nonetheless, frontier markets offer other benefits such as higher expected growth and diversification. Market Vectors Vietnam ETF (VNM) provides significant diversification to a global portfolio, with a 1 year correlation of daily returns vs. the S&P500 of 0.58, which is very low compared to its more popular peers tracking “mature” emerging markets. China, Hong Kong, Brazil and Mexico, all have correlations approximately in the 0.8 to 0.9 range, as shown below:

The data above implies that an investor with positions in both the S&P500 and the emerging markets listed above, will experience losses in both the U.S. and international portion of his or her holdings when the U.S. market drops. As much as “a rising tide lifts all boats”, a falling tide sinks all boats when they are highly correlated. Investors who diversify their U.S. investments with holdings in frontier markets such as Vietnam, will be better hedged when the U.S. market suffers. Traditionally, equity investors have hedged their equity portfolios by investing in bonds, though frontiers markets, such as Vietnam, offer good diversification benefits with a much higher (though volatile) expected return.