The MSCI Frontier Market Indices encompass a collection of indices that track the stock market performance in frontier economies. A frontier market, as defined by MSCI, refers to a country with a nascent economy that is less advanced than those in emerging markets. These markets are characterized by their developing stages of industrialization, evolving infrastructures, smaller capital markets, and lower levels of income compared to emerging markets. Frontier markets offer potential for growth but are often marked by higher investment risks and lower liquidity compared to more developed markets.
MSCI country indices are designed to include about 85% of the free float-adjusted market capitalization in each country. This approach ensures that the indices provide a comprehensive representation of the large and mid-cap segments of the respective national equity markets. The country index versions in the charts above are all denominated in USD, capitalization-weighted, and do not include dividends.
The chart above shows a heat map depicting the correlation coefficients among various frontier market indices. Each index is represented on both the x and y axes, with intersections revealing the strength and direction of their correlation. A correlation coefficient of +1 indicates a perfect positive correlation, implying that two indices moved in the same direction during the specified time window. Conversely, a coefficient of -1 signifies that the indices moved in opposite directions. Colors range from deep blue, indicating a negative correlation, to dark red, signifying a strong positive correlation.
The correlation coefficient is important to consider for diversification because it helps investors assess the potential benefits of including different assets in their portfolios. Diversification is the practice of spreading investments across different asset classes to reduce risk. In his book Principles, Ray Dalio called diversification the “Holy Grail of Investing”. He realized that with fifteen to twenty uncorrelated return streams, he could dramatically reduce the risks without reducing the expected returns.
The minimum spanning tree (MST) simplifies the data from the correlation matrix above by retaining only the strongest correlations. If two indices are connected, it means that they are positively correlated and that they tend to move in tandem. By analyzing the structure of the MST, one can identify clusters of indices that move together. This visual tool is especially beneficial when considering international portfolio diversification. In fact, Marti, Gautier, et al. (2017) found that the optimal Markowitz portfolio is found at the outskirts of the tree and that the tree shrinks during a crisis.
*The country indices marked with an asterisk are classified by MSCI as "Standalone Indices" and are not part of the MSCI Frontier Markets Index. They represent individual markets with significant barriers to foreign investment, such as stringent capital controls and regulatory constraints.
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