When the stock market turns ugly, the quest for "non-correlated assets" intensifies...
WHAT'S KNOWN on Wall Street as a "non-correlated asset" is just fancy talk, says Chris Mayer for the Rude Awakening, for something that doesn't move in lock-step with the overall market.
When the market falls, a non-correlated asset might actually rise, or at least hold its own. The correlation between changes in this asset's price and changes in the broader market is either zero or near enough to smooth out your overall portfolio's moves.
Gold is a classic example. Its price actually tends to rise during times of stock market distress, suggesting a negative correlation. (Gold up, stock market down and vice versa.)
Very few asset classes, however, can rival Gold's long history of genuine non-correlation. Imposters abound. The imposters might move independently of the overall market for months or years at a time, thereby creating the impression that they are non-correlated. But when the markets really turn nasty, investors often learn that their "non-correlated" asset – unless it's Gold Bullion – tumbles just as sharply as an S&P 500 Index fund.
However, some investors think they've found a reliable new non-correlated asset: so-called "frontier markets".
Merrill Lynch recently created an index not only to track them, but for investors to buy and sell, too. These frontier markets include Pakistan, Kuwait, the United Arab Emirates (UAE) and other markets throughout Africa and the Middle East. They also include Vietnam, Kazakhstan, Cyprus and others...individually too small for institutions to invest in, but worth buying – apparently – if you cobble them together into a new index that allows you to buy and sell the whole basket.
Merrill Lynch's new Frontier Index tracks the 50 largest companies in 17 frontier markets. All told, the market value of all these companies combined is only about $330 billion – or about that of General Electric in the United States.
Right now, the index heavily tilts toward the Middle East, with 50% of the index in the region. Asia is the second largest component, with 23%, followed by Europe at 14% and Africa at 13%.
As for industry groups, banks usually features among the biggest companies in any emerging market. So banks and financial service companies represent about 65% of the index. Oil and gas is the next largest sector, weighing in at 13%. As far as countries go, the top three are the UAE (23%), Kuwait (18%) and Pakistan (14%).
So far, these frontier markets have lived up to their advance billing of not following the broader markets. Since Sept. 30, for example, the frontier markets actually gained 31% while the broader global market lost ground. Merrill Lynch back-tested the index several years and found that between Feb. 2000 and Dec. 2007, the index return's correlation with the S&P 500 was only 32%.
So basically, that means that about two-thirds of the time, the frontier markets zigged while the S&P 500 zagged.
Sure, I love the idea of frontier investing – because I'm an optimist when it comes to global trade and booming overseas markets. Maybe it's my globe-trotting that's skewed my view. But when I travel overseas, I see great opportunity. I see people building businesses. I see the impact of global market forces on local energy, food and resource markets. I see the world getting smaller.
I'm long-term bullish on markets such as the UAE, Kuwait, Vietnam and others. But I also realize that the ride in some of these markets will be absolutely gut-wrenching. Just look at Vietnam.
The Vietnamese economy is growing somewhere between 7-9% per year. It is a cheaper place to do business than many other parts of Asia. Hence, Vietnam continues to attract a strong flow of investment.
While I liked what I saw going on there, I found no direct investment ideas. The market is just too small and illiquid. Heck, before March 2002, the market traded only on alternate days! Moreover, as with most of these frontier markets, Vietnam suffers from poor disclosures and low transparency. When you invest here, you're really not sure what you're getting.
I remember listening to Carlo Cannell, a very good investor at Cannell Capital, talk about his trip to Vietnam and his investments there. This was back in May 2007. The theme was investing in the dark. In Vietnam, he basically made many blind bets on lots of companies, figuring enough of them would work out.
Since then? The Vietnam market has tanked.
Perspective, though, is everything in markets. A chart of Vietnam looks nasty, with a near 50% drop from the high in less than a year. But as recently as July 2005, the index was only 250. You'd still have more than doubled your money in less than three years. In 2000, it was only 100. Investors are up six-fold from 2000, which is a lot better than an investment in the S&P 500 Index of any other major Western bourse.
And that's really the key to the whole frontier market idea. As an investor, what's most important is what happens over the years.
I'm skeptical of the idea of frontier markets as a "non-correlated asset", however, and for all seasons. They certainly can't match Gold. Links between these small markets and their bigger brothers are probably stronger now than in the past. Vietnam, for example, depends heavily on foreign investment. Vietnam's currency, the Dong, is still pegged with the Dollar.
So we have to be careful in taking the past and saying the future will work the same way. Even though, on their own merits, as growing economies, I like frontier markets for the long haul.
For now only institutions can buy Merrill's index. But individual investors can still invest in frontier markets through mutual funds. The recently launched T. Rowe Africa & Middle East Fund is one. Just be sure you can stomach the major gyrations that come with working the frontier of investing.
Worst case? You'll lose money in many different languages, not just English.