3. From a portfolio positioning standpoint, frontier markets continued to serve as a useful diversification tool, with low correlations not only to other major asset classes but among the constituent countries themselves. This intra-country diversification can help reduce volatility, as we saw in October.
FM provides exposure to up to 20 countries, helping to mitigate the volatility associated with concentration risk.
Market Realist – Frontier markets are good diversifiers.
The graph above shows the correlation coefficient between frontier markets (FM), emerging markets (EEM), the S&P 500 (SPY)(IVV), and developed markets excluding the US and Canada (EFA)(VEA). Frontier markets have low correlations with other asset classes, whereas the correlation between the other markets is high.
The correlation coefficient always lies between -1 and 1. It’s the extent to which two securities move with each other. A correlation coefficient of 1 means that the two securities move in absolute tandem with each other. A coefficient of -1 means the two securities are inversely related. A coefficient of 0 means the two move in random directions. It’s the most desirable coefficient as far as portfolios are concerned.
The correlation between frontier markets and the S&P 500, considering monthly returns for ten years, is 0.38 compared to 0.81 for the S&P 500 and emerging markets. The correlation between frontier markets and developed markets stands at 0.53, and the correlation coefficient between frontier markets and emerging markets is 0.43.
This means that frontier markets add diversification benefits to a portfolio containing only US stocks, emerging markets, and developed markets.