Merrill Lynch Global Research has introduced a new index, which is designed to identify the largest and most liquid stocks in so-called frontier markets, which are developing economies with an undeveloped equity market.

The Merrill Lynch Frontier Index is composed of 50 stocks in the frontier markets of Europe, the Middle East, Africa and Asia, reflecting 17 countries, including the United Arab Emirates, Kuwait, Nigeria, Morocco, Pakistan, Kazakhstan, Vietnam and Cyprus.

Stocks listed in the Middle East make up 50.0% of the new index, followed by a 22.6% share for Asia, 14.1% for Europe and 13.3% for Africa. The top three countries in the index are the UAE (23.1%), Kuwait (18.1%) and Pakistan (13.6%). Banks dominate the index (39.4%), followed by financial services companies (25.7%) and oil and gas firms (13.6%).

The hallmarks of frontier markets include undercapitalization and weaker regulatory frameworks, as well as lower levels of foreign ownership, borrowing and transparency, Merrill explained.

It reported that frontier markets have outperformed both emerging and developed equity markets since January 2000, with 20% annualized returns, compared to 12% for emerging markets and 1% for developed markets. While market risk is high in frontier markets, they also have strong economic growth potential.

They are also less correlated with traditional markets than many other assets. From February 2000 to December 2007, the monthly correlation of returns for the S&P 500 was 32%, compared to 73% for emerging markets and 96% for developed markets.

Michael Hartnett, Merrill Lynch chief global emerging markets equity strategist, said, “The ultimate goal for many investors in 2008 is to find assets which are not closely linked to the fortunes of Wall Street. Frontier market returns are far less correlated to the performance of the S&P 500 than emerging and developed equity markets.”

To be included in the index, stocks must have a market capitalization of at least US$500 million, a three-month average daily turnover of at least US$750,000 and a foreign ownership limit above 15%. The composition of the index will be reviewed twice a year, in February and August.