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The Merrill Lynch Frontier Index is composed of 50 stocks in the frontier markets of Europe, the Middle East, Africa and Asia that covers 17 countries, including the United Arab Emirates (UAE), Kuwait, Nigeria, Morocco, Pakistan, Kazakhstan, Vietnam and Cyprus.
Countries with a developing economy but an undeveloped equity market are considered frontier markets. They tend to be young, thinly traded equity markets with weaker regulatory frameworks, lower levels of transparency and low levels of foreign ownership.
Frontier markets represent nearly one billion people, have a nominal GDP of $2.7 trillion, and an equity market cap of $1.9 trillion. In contrast, emerging markets have seven billion people, a nominal GDP of $12.3 trillion, and a market cap of $12.8 trillion.
ôThe ultimate goal for many investors in 2008 is to find assets which are not closely linked to the fortunes of Wall Street,ö says Michael Hartnett, US-based chief global emerging markets equity strategist at Merrill Lynch. ôFrontier market returns are far less correlated to the performance of the S&P500 than emerging and developed equity markets.ö
From February 2000 to December 2007, the monthly correlation of returns for the S&P500 and frontier markets was 32%, compared to 73% for emerging markets and 96% for developed markets, according to Merrill Lynch.
Harnett says the best reasons to invest in frontier markets are: strong and uncorrelated equity market returns; undercapitalised markets; under owned markets; strong economic growth potential; and underleveraged economies.
ôThe Frontier theme is gaining strong traction in 2008 thanks to its perceived lack of correlation with both emerging and developed equity markets,ö Harnett says. ôThe Middle East is easily the best performing equity region year-to-date.ö
Stocks listed in the Middle East make up 50% of the new index, followed by Asia with a 22.6% share, Europe with 14.1%, and Africa with 13.3%. The top three countries represented in the index are the UAE (23.1%), Kuwait (18.1%) and Pakistan (13.6%).
Sector-wise, banks dominate the index (39.4%), followed by financial services companies (25.7%), and oil and gas firms (13.6%).
Frontier markets have outperformed both emerging and developed equity markets since January 2000, with 20% annualised returns, compared to 12% for emerging markets and 1% for developed markets, according to Merrill Lynch. While market risk is high in frontier markets, they also have strong economic growth potential, the firm adds.
ôFrontier equity markets offer investors a unique opportunity to diversify their portfolio as well as to benefit from what we believe will be the markets' significant long-term growth potential,ö says Henry Hall, head of global emerging market equity-linked sales, structuring and financing for EMEA.
To be included in the index, stocks must have a market capitalisation of at least $500 million, a three-month average daily turnover of at least $750,000 and a foreign ownership limit above 15%. The composition of the index will be reviewed twice a year, in February and August.
The index includes the following stocks, which have among the highest weightings as of now: Mobile Telecommunications in Kuwait; Kazmunaigas Exploration in Kazakhstan; Oil and Gas Development Company in Pakistan; Bank of Cyprus and Marfin Popular Bank in Cyprus; and Emaar Properties in the UAE.
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