LONDON, March 31 (Reuters) - Frontier equity indexes are about to lose two of their biggest and most liquid markets, Pakistan and Argentina, a change that may deepen disenchantment with an asset class where investment flows have stagnated in recent years.
Once-vaunted frontier markets -- encompassing riskier African, Latin American and Asian countries plus some small developed ones such as Slovenia and Lithuania -- have seen share listings, trading volumes and returns all broadly fall short of expectations, according to many investors.
About $6.4 billion is currently under management with frontier equity funds, down from over $8 billion in 2014, says fund research firm eVestment. If the main index serving these markets loses Pakistan, Argentina and Nigeria, funds could be left with far fewer investable stocks, in countries like Ivory Coast and Jordan.
“The index is already a little bit skewed and not very attractive as a basket of stocks to invest in ... The removal of Pakistan, and maybe Argentina will make it more and more irrelevant,” said George Birch Reynardson, who runs a frontier fund at Somerset Capital.
In its May index review, MSCI will move Pakistan from “frontier” to “emerging” markets, a segment comprising larger, more liquid developing economies such as Brazil or Russia. Pakistan has a nearly 10 percent weighting in the parent frontier index.
MSCI is also consulting on whether Argentina, with an around 17 percent weight, should follow suit after it abolished capital controls and opened access to its markets. Nigeria, which comprises another 10th, could be ejected altogether due to capital controls.
Once Pakistan goes, the parent MSCI frontier index -- containing around 124 stocks from 30 countries -- will be more than a fifth weighted to Kuwait.
Fellow index provider S&P Dow Jones Indices will reclassify Pakistan from frontier to emerging from September.
The rejigs will complicate fund strategies.
Steven Holden of Copley Fund Research tracks 25 active frontier funds with assets of $5.1 billion. He estimates they have an average weighting of 15.5 percent in Pakistan and 9.5 percent in Argentina, with MSCI’s Frontier Index the dominant benchmark.
The frontier markets moniker was coined in the 1990s by the World Bank’s International Financing Corp, but index compilers S&P Dow Jones and MSCI launched trackable indices from 2007.
MSCI’s index soared 42 percent in 2007, prompting the launch of scores of specialised funds hoping for outsized returns from small but fast-growing economies where rising incomes would spur demand for mobile phones and cars.
The expectation was these countries would follow the path trodden by the likes of Brazil and Russia, attaining full-fledged emerging markets status as their markets became bigger, more liquid, and with greater foreign participation.
Inflows and assets under management rose steeply from 2012 but peaked in late 2014 and have not recovered, according to Copley Fund Research.
A decade after its launch, just $10 billion is benchmarked to MSCI’s frontier index versus almost $2 trillion following the emerging index.
That is partly because there are far fewer listed companies. Frontier markets saw 59 initial public offerings raising $8 billion in 2007 compared to 16 listings raising under $800 million last year, according to ThomsonReuters data.
One factor could be low commodity prices. But it also mirrors broader emerging equities where funds suffered losses and outflows in 2011-2015 amid faltering growth and reforms.
“There was a lot of excitement about the size of the GDP that would come to market, but generally it hasn’t in frontier markets, and to some extent in emerging markets,” said John-Paul Smith, founder of consultancy Ecstrat, who in 2010 correctly called the underperformance of emerging equities.
Index changes will push funds to look beyond the benchmarks, Smith said, describing MSCI’s frontier index as “absurd”. But while frontier markets had not delivered, he added, some of the funds have -- “a critical distinction to make.”
MSCI’s response to losing Pakistan has been to lower the market cap a company needs to qualify for some of its frontier indexes, including the Frontier Markets 100 index, containing the largest and most liquid stocks.
But smaller companies usually trade less, making it hard for bigger funds to transact.
Pakistan and Argentina each have a market capitalisation of $80-$100 billion -- a fraction of India’s $750 billion or Russia’s $525 billion but huge compared to most frontiers.
Georgia is mentioned by some investors as a possible contender for MSCI inclusion. Yet Tblisi’s stock exchange has a market cap under $750 million and often turns over just $100 a day.
Investors still urge MSCI to expand the index. Robeco frontier fund manager Cornelis Vlooswijk argues once new countries join and existing ones like Kenya get bigger weightings, the asset class will grow.
“It is a bit of a chicken and egg story -- MSCI is normally pointing to the fact that their liquidity is low - but of course if you are not in an index, than liquidity is lower than most of the index names.” (Editing by Catherine Evans)