2015 Cambridge Business & Economics Conference ISBN : 9780974211428
Evaluating the Efficiency of Frontier Equity Markets in Caribbean Economies: Equity Market Efficiency in Barbados, Jamaica and Trinidad and Tobago
Stephen O. Morrell, Ph.D.
Professor of Economics and Finance
Andreas School of Business
Barry University
Miami Shores, Florida USA 33161
Sean Cooney
Analyst
Energy Investment Banking
Capital Markets Division
Bank of Montreal
Calgary, Alberta Canada T2P 1G1
_____________________
Corresponding author: Stephen O. Morrell, Ph.D., Professor of Economics and Finance, Andreas School of Business, Barry University, 11300 N.E. Second Avenue, Miami Shores, Fl. USA 33161. Phone: 305 899 3513; Fax: 305 892 6412; Email:
Abstract
Professional investors have only recently turned their attention to so-called Frontier equity markets. Academic researchers have been even later in starting to research Frontier equity markets. Asset pricing, the distributions of returns and risks, and potential diversification benefits of Frontier equity markets have been the primary topics of investigation among professional investors and academic researchers.
However, the informational/pricing efficiency of Frontier equity markets and its evolution over time have not been systematically analyzed and evaluated by either professional investors or academic researchers – although this issue is seemingly the essence of market valuation assessments as well as broader issues associated with capital market effectiveness and economic development.
Our research seeks to begin to fill this void. We employ a variety of empirical techniques to ascertain the efficiency of equity markets in the three Caribbean Frontier market countries of Barbados, Jamaica, and Trinidad and Tobago, and to determine if these markets have become more efficient over time. The empirical techniques include analyzes, assessments, tests and evaluations of return autocorrelations; adjusted Dickey-Fuller tests for unit roots; runs tests; and Lo-MacKinlay, Chow-Demming and Wright variance ratio tests as well as rolling Lo-Mackinlay variance ratio tests for dynamic changes to market efficiency.
Our empirical techniques indicate pricing and valuations in all three frontier markets are inefficient and predictable. Additionally, the evidence is weak that any of the three markets have become more efficient over time. However, thin trading, illiquidity and non-linearities may be influencing our results.
JEL classification: F37; G14; G15
Keywords: Frontier markets; Market Efficiency, Forecasting Returns
I. Introduction
Frontier equity markets have quite recently started to attract attention from the professional investment community as well as from academic researchers. This heightened interest reflects a variety of factors, including economic, investment and capital market growth prospects in so-called frontier countries.
The United Nations(2011),for example, notes that from 2000 – 2009 real output increased at an annual average rate of 3.3 percent in countries classified as developed versus 6.9 percent in those classified as developing (including frontier), and also that 2012 – 2015growth is forecasted to average 1.6 percent for developed countries compared to 5.7 percent for developing ones. Speidell (2011) reports that while Frontier countries account for 22 percent of the world’s population and 7 percent of its nominal GDP they only represent approximately 3 percent or roughly $1.9 trillion of 2010 world equity market capitalization. Emerging markets, in contrast, accounted for 63 percent of global population, 42 percent of nominal GDP and 42 percent or about $26 trillion of 2010 global equity market capitalization. Moreover, equity market capitalization relative to GDP in early 2011 totaled only 17 percent in frontier markets versus 45 percent for emerging and 72 percent for developed markets, respectively.
The heightened attention directed to frontier equity markets from the professional investment community can be seen in the following activities:
· The establishment of criteria for classifying markets as frontier.
· The design and development of frontier stock market indices.
· The subsequent design, development and marketing of investable products tied to frontier stock market indices.
· The growth in the market capitalization and number and asset sizes of the investable products.
Four organizations at present, S&P/IFC, MSCI/Barra, the Frank Russell Company and the Financial Times have been primarily responsible for establishing and defining criteria for classifying equity markets as Frontier, and then designing and developing indices to measure market performance. While the criteria and the weight given to each criterion vary somewhat across organizations they include:
· Liquidity screens for individual companies;
· Minimum free float adjusted market capitalizations relative to emerging markets.
· The extent of any investment restrictions.
· Qualitative evaluations of a nation’s capital market development, governance and informational transparency
· Exposure to each of the world’s five global regions.
S&Ps Aye Soe (2007) and Speidell (2011) offer even more basic definitions of Frontier markets. As Soe notes, “Frontier markets are the subset of emerging markets deemed to be relatively small and illiquid, even by emerging markets standards.” Speidell notes that of the 211 countries covered in the World Bank’s World Development Indicators 117 have independent stock markets. Morgan Stanley Capital International (MSCI) places 24 of the 117 in the Developed group and classifies 22 as Emerging. The remaining 71 equity markets are then categorized as Frontier.[1]
Table 1 summarizes basic features of the four primary Frontier equity market indices:
Table 1: Frontier Equity Market Indices
InceptionNumber of:2013Equity Market Index
Index Date Countries Companies Capitalization Construction
S&P/IFC 2007 37 563 $296 billion MVW
MSCI/Barra 2009 25 371 $228 billion MVW
Russell 2008 41 209 $941 billionMVW
FTSE 50 2010 25 50 $ 48 billion MVW
MVW = market value weighted
Sources: All accessed August 11, 2014
S&P/IFC:
https://www.spindexdata.com/idpfiles/emdb/prc/active/factsheets/Factsheet_SP_Frontier_BMI.pdf
MSCI/Barra
http://www.msci.com/products/indices/country_and_regional/fm/performance.html
Russell
http://www.russell.com/indexes/data/Frontier/russell_frontier_indexes.asp
FTSE 50
http://www.ftse.com/Indices/FTSE_Frontier_Indices/Index_Rules.jsp
As an illustration of the growth in Frontier markets Morningstar (2012) currently provides research on nine separate Frontier open-end funds and five Frontier exchange traded funds (ETFs). Total assets of the nine open-end funds were approximately $900 million as of June 30, 2014 while total assets of the five exchange traded funds were about $400 million. The open-end funds ranged in size from Franklin Templeton’s $500 million Frontier Market Fund to Nile Capital’s $4million Nile Pan Africa Fund. With regard to exchange traded funds Guggenheim – Bank of New York/Mellon’s Frontier Market fund of $142 million in assets is the largest and Market Vector’s Gulf States Index with assets of $11 million is the smallest in the Morningstar universe. All of these funds date from mid-to-late 2008. The median compound annual return over the three year period June, 2009 – June, 2012 for the open-end funds is 5.22 percent, while it is 6.56 percent for the exchange traded funds.[2]
The scant academic research on frontier markets has focused on topics such as their integration with developed and emerging markets, their portfolio diversification potential, and the distributions of their returns and risks. Berger, et.al. (2010) found extremely low levels of integration between frontier and developed markets and, hence, significant diversification benefits. Speidell (2011) contends frontier markets offer higher Sharpe ratios than either developed or emerging markets – based on higher returns with about the same amount of risk as those found in emerging markets.
The pricing efficiency of Frontier equity markets and its evolution over time, however, have not been systematically analyzed and evaluated by either professional investors or academic researchers – although this issue is seemingly the essence of market valuation assessments as well as broader issues associated with capital market effectiveness and economic development. Our research seeks to begin to fill this void.
We employ a variety of empirical techniques to ascertain the efficiency of equity markets in the three Caribbean Frontier market countries of Barbados, Jamaica, and Trinidad and Tobago, and to determine if these markets have become more efficient over time. The empirical techniques include analyzes, assessments, significance tests and evaluations of return autocorrelations; adjusted Dickey-Fuller tests for unit roots; runs tests; and Lo-MacKinlay, Chow-Demming and Wright variance ratio tests as well as rolling Lo-MacKinlay variance ratio tests for relative comparison as well as dynamic changes to market efficiency.
Our choice of researching the efficiency of equity markets in Barbados, Jamaica and Trinidad and Tobago is based on four factors. First, these three Caribbean nations have the closest geographic proximity to the U.S. of all the 47 nations contained in the above Frontier market indices. The second reason is these three countries are the only predominately English speaking ones among the Latin America and Caribbean Region components of the above Frontier market indices. The third factor is that each country obtained its independence from Great Britain in the early –to-mid 1960s and possessed similar, shared and inherited British institutions.[3] The fourth reason is that all three nations are members of CARICOM and thus, in addition to inherited British institutions, share similar trade and financial regulatory structures.
The contribution of our research is thus twofold. First, to initiate the examination of market efficiency in Frontier markets and, in the second instance, to focus on the efficiency of Frontier equity markets in countries geographically and – in some dimensions – institutionally and culturally close to the United States.
The remainder of the paper is organized as follows. Section 2 reviews the literature on the efficient markets hypothesis. However, as this literature is voluminous reflecting its status as one of the most widely researched and debated topics in all of financial economics our focus in Section 2 is on research that has a bearing on the efficiency of Frontier equity markets. Section 3 discusses the statistical techniques we employ to test for the presence and evolution over time of equity market efficiency in the three Caribbean countries. Section 4 presents the data we employed in the research and an overview of each nation’s equity market. Section 5 presents results of a battery of statistical techniques that test for market efficiency. Section 6 presents our conclusions and suggestions for further research.
II. The Efficient Markets Hypothesis and the Evolution of Market Efficiency in Frontier Equity Markets
The debate about the Efficient Markets Hypothesis is undoubtedly one of the most widely researched topics in all of financial economics. In their survey of the empirical literature on the evolution of stock market efficiency Lim and Brooks (2011) cite 320 journal articles, monographs and books dating from 1955 through 2009 in the References section of their paper. However, even their extensive reference list is not exhaustive as it excludes Kendall’s (1953) seminal article which launched the empirical research on the efficient markets hypothesis. LeRoy’s (1989) survey article focusing on efficient markets and martingale stochastic processes had 167 References, while dueling, back-to-back articles by Shiller and Malkiel (2003) on the validity of the efficient markets hypothesis and behavioral finance cite a combined 112 distinct references in their respective bibliographies.
In the broadest sense,the efficient markets hypothesis is the theory of equilibrium in competitive markets applied to security markets - most notably equity markets. As in the theory of competitive equilibrium, the ongoing quest for economic profits in equity markets causes investors to allocate resources and incur costs up to the point where the net marginal returns are zero. At this point equity prices will fully reflect the marginal valuations and marginal risk-adjusted opportunity costs of the marginal investor.
Information, knowledge and technology are the critical resources to which investors allocate resources and incur costs in their efforts to consistently earn economic profits in equity markets. Any information that can be used to indicate whether or not the existing level of stock prices provides an opportunity for economic profit will be seized upon by investors, and quickly incorporated into prices until the economic profit is dissipated. The same behaviors would be true about knowledge regarding such things as the processes of price formation, trading rules, patterns, cycles and trends in equity prices. Technologies, especially to the extent they lower the costs of acquiring information and executing trades, are also resources investors highly value and will quickly acquire, again to the point where economic profit from so-doing becomes zero.[4]
The lessons of market efficiency emerge directly from the perspective that equity prices reflect equilibrium outcomes in competitive markets populated by rational investors. These lessons include:
· Equity prices reflect all relevant, publicly available information (also known as ‘weak-form’ efficiency).
· Investors cannot consistently earn economic profits (excess risk-adjusted returns) in efficient equity markets.
· Active investment management strategies cannot consistently succeed.
· Since equities are correctly priced and not consistently mis-priced scarce capital and savings will not be wasted but instead efficiently allocated to markets/countries, sectors and firms offering the highest expected risk-adjusted returns/ value added.
· As equities are not consistently mis-priced and fully embed all relevant publicly available information then it is new, relevant information which drives equity price changes. Moreover, changes in stock prices will be complete and rapid in response to the release of new information.
· By definition, new information must be non-forecastable and therefore unpredictable. Consequently, stock price changes in efficient markets should also be unpredictable and non-forecastable.
Evolution and progress towards increasing market efficiency are especially vital for Frontier equity markets in light of the research which has clearly demonstrated the key contributions of more efficient markets to a nation’s development. Levine and Zervos (1998) find financial institutions and stock markets with high liquidity positively predict capital accumulation, productivity improvements and greater economic growth.
Bekaert and Harvey (1997) set out numerous arguments and evidence supporting the idea that efficient markets increase economic growth in emerging economies and, by implication, in frontier economies as well. They demonstrate that the cost to investors of diversifying decreases as equity market efficiency improves and in the process corporations find it less expensive to raise equity capital since investors can more easily reduce firm-specific risk. Bekaert and Harvey (1997) further argue that countries lacking efficient capital markets force companies, not stock markets, to provide this diversification. Companies accomplish this by concentrating investments in low-risk projects that may conflict with the firm’s comparative advantages. In contrast, as equity markets become more efficient investors may achieve greater diversification through lower costs of investment in multiple companies and issuing companies can focus on higher risk and more specialized projects that will increase economic growth for the home country. More efficient equity markets can also aid in the management of moral hazard issues by holding firm executives accountable for the long-term value of a firm as evidenced by its share price. As executives are held to higher standards of accountability for the value of the firms they lead economy-wide productivity can increase boosting a nation’s economic growth in the process. Moreover, the greater ease of change in ownership as equity market efficiency progresses serves as a deterrent to executives from engaging in productivity decreasing behaviors.