- MSCI Frontiers Market index down 11% in six months to 31 Jan
- High number of countries involved in oil production
- Frontier markets are good value on a p/e ratio of 11
Having been the darlings in the emerging markets growth story, frontier markets were ousted in the second half of 2014 to become investment pariahs.
This followed the phenomenal crash in the oil price, as many frontier economies rely heavily on oil exports.
Subsequently, a number of funds investing in the region have struggled as weakening currencies, geopolitical wobbles and concerns over the actions of the US Federal Reserve have also taken their toll.
However, not all frontier markets have suffered; a number have benefited from lower prices, while catalysts for strong growth remain, leaving plenty of opportunities for adventurous investors.
As the price of Brent crude oil began its spectacular descent from around $115 (£75) a barrel in late June last year to less than $50 a barrel in late January 2015, frontier markets suffered a similar fall.
The MSCI Frontier Markets index shed close to 11 per cent of its value in the six months to 31 January, compared with a loss of just 0.8 per cent in emerging markets and a gain of close to 5 per cent in developed markets over the same period.
The losses were largely due to the high number of frontier market countries involved in the production and export of oil.
The largest markets in the MSCI Frontier Markets index belong to Kuwait (22.7 per cent) and Nigeria (15.5 per cent), where the oil and gas sectors account for 60 per cent and 35 per cent of gross domestic product, and 95 per cent and 90 per cent of total export revenues, respectively.
The crash also damaged frontier market currencies. Some, such as the Nigerian naira, have fallen by as much as 20 per cent over the past 12 months, partly in anticipation of weaker export revenues.
Frontier currencies have also been hurt by the US Federal Reserve's impending interest rate hike. This is generally interpreted as bad for emerging assets and currencies, as it is expected to send US investors flocking back to their home market.
Andrew Lister, manager of the Advance Frontier Markets investment trust, says: 'Frontier markets have been hampered by the halving of the oil price, the like of which has only ever been seen a few times in history and has never happened at such a pace.
'We also saw continued weak commodity prices and deterioration in the terms of trade, which was seen mostly in currencies. You could say there has been a perfect storm for the sector.'
GOOD FOR SOME
However, it hasn't been all bad news for frontier markets. It is true that the major frontier markets index is dominated by oil and commodity producers. However, a number of frontier countries are net importers of natural resources and beneficiaries of lower oil prices.
Several Asian economies, such as Bangladesh, Pakistan and Sri Lanka, are net importers of oil and enjoyed strong gains in the second half of 2014. For example, in the six months to 31 January, the MSCI Bangladesh index gained an impressive 34.2 per cent, while MSCI Nigeria shed 32.5 per cent.
He says: 'No single global issue is a headwind or tailwind for the sector, as the frontier markets grouping is not homogeneous. Frontier markets are very much driven by local issues.'
It is the combination of these different markets that works to keep volatility surprisingly low in many frontier market portfolios.
Over the past three years, Advance Frontier Markets and BlackRock Frontiers have delivered the best risk-adjusted returns (as determined by the Sharpe ratio) in the Association of Investment Companies' global emerging markets sector, which contains funds focused on far bigger, more established regions such as India and China.
Nonetheless, in those countries where the prices of oil and commodities tend to dictate market performance, challenges have come thick and fast, and show few signs of dissipating.
Lister says: 'I wouldn't say everything we have seen recently is temporary; I think the lower oil price is here to stay, but oil exporters with weak sovereign balance sheets (low cash reserves) are at risk - Nigeria especially.'
The price of natural resources is not the only potential stumbling block for frontier markets. As seen in West Africa and the Middle East recently, frontier market countries tend to be politically unstable, and many face serious structural threats such as epidemics, terrorism and environmental disasters.
As these risks are largely unavoidable, Vecht says, more than anywhere else, price is paramount in frontier markets.
He says: 'These markets are called frontier markets because they are located in unstable regions. It is dangerous to think these places are safe; there is no such thing as safety and stability in these markets. But then it's a question of the degree of instability priced in.
'For example, we have 12.4 per cent of our portfolio in Pakistan. The country is obviously a dangerous place to invest, with a difficult political backdrop, but I would say much of that is priced into the market.
'Pakistani banks are trading at seven times price/earnings (p/e) with 4 to 5 per cent dividend yields. And this is a country with a lot of growth ahead of it if things turn out to be right.'
This compares with a p/e ratio of 13.5 times and a dividend yield of 2.6 per cent for the MSCI Emerging Markets index and a ratio of more than 19 times with a dividend yield of just 2.4 per cent for the MSCI World index (dominated by the US).
Investors should rightly expect to pay less for riskier investments. However, according to Lister, the differential is now 'quite wide', making frontier markets particularly good value.
Moreover, frontier market companies' low levels of debt and strong cash flows mean they pay particularly healthy dividends, which compensate for periods of underperformance over the long term.
CROSSING THE FRONTIER
For those looking to access frontier markets, the best route is almost always through an investment fund or trust run by an experienced manager with in-depth knowledge of these markets.
Ben Yearsley, head of investment at Charles Stanley, observes that investment trusts are particularly suited to the task. He says: 'I think investment trusts are suited to frontier markets, as there is always potential for a liquidity crunch that could scupper an open-ended fund.'
Yearsley highlights Vecht's trust - BlackRock Frontiers - as a strong option.
The trust, established in 2010, initially bombed following some unfortunately timed calls on Nigerian banks, but over the past three years to 1 June it has outperformed every other trust in the global emerging markets sector, with a return of 63.7 per cent.
Lister's trust, Advance Frontier Markets, the only other UK-listed frontier markets trust, is different from Vecht's in that it invests in the funds and trusts of other global managers. Advance's annual management charge of 1.25 per cent is slightly cheaper than BlackRock's 1.5 per cent and the trust is marginally less volatile. However, its returns tend to lag behind its competitor.
In the open-ended space, Templeton Frontier Markets is arguably the best-known fund, while Schroder ISF Frontier Markets Equity, an offshore vehicle, is available to UK private investors. But none of the open-ended funds has produced noteworthy performance, and they are far less well-suited to the region than the trusts.
For those wedded to open-ended vehicles, Yearsley suggests an emerging market or country specialist fund with some frontier market exposure such as Jupiter Global Emerging Markets, which has around 8 per cent of its portfolio in South Africa and the UAE, or offshore vehicle Old Mutual Pan African.
Choosing where to invest in frontier markets is arguably secondary to choosing how to invest - and that should always be with patience. Frontier markets are highly diversified and cash-generative, but they are very risky places, so investors' time horizons should be at least five to 10 years. But for those willing to be patient, frontier markets offer strong growth opportunities.
Lister concludes: 'I wouldn't recommend a frontier market fund for my granny's pension, but I would recommend that she invest in one for her grandchildren, as in 20 years' time Africa is going to look a very different place. Long term, it's a compelling opportunity; over five to 10 years, if you don't make money, something very irregular has happened.'