We look at the world’s younger markets, and the realistic investment timeframes.
If developed markets are vanilla, emerging markets provide a portfolio’s spice. That’s even more the case for their younger, more volatile siblings: frontier markets. This market category is populated by countries such as Kazakhstan and Nigeria that are not yet developed enough to be considered ‘emerging’.
Frontier markets are often billed as being the most dynamic, fast-growing investment bets. But like emerging markets, they have not performed well over the past decade. So could now be a good time for long-term, risk-taking investors to get involved?
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How are frontier markets different from emerging markets? We can look at emerging markets as the “big eight”, says Sam Vecht, manager of the BlackRock Frontiers investment trust. These countries – Brazil, Russia, India, China, South Africa, South Korea, Taiwan and Mexico – are often in the limelight. Meanwhile, frontier countries form a “forgotten 40”, a diverse collection of countries on the edge of public attention.
These markets are relatively small. The combined value of frontier markets is just $715 billion (£543 billion), according to Bloomberg data. In comparison, emerging market stocks are worth $20 trillion. To be included in the MSCI Frontier Markets index, countries need to exhibit some openness to foreign ownership and to have at least two companies each worth a minimum of $800 million.
Frontier market businesses are generally tiny. The median market capitalisation of the top 1,000 firms in frontier markets is just £121 million, compared with £4.9 billion for the top 1,000 across emerging markets, says Tom Delic, a fund manager at Seneca Investment Managers. This is what makes them attractive. He explains: “Smaller, illiquid markets often make it difficult for larger investors to build meaningful positions, which creates pricing inefficiencies smaller investors can take advantage of.”
When it comes to foreign inflows into frontier markets, just 10% is estimated to come through exchange traded funds while active funds take the lead, according to Bloomberg data.
This is not surprising given the lack of transparency and information on these markets. There is potential for knowledgeable investors to gain advantage when a lack of information creates a disparity between the value of a company, its potential for growth and its share price.
That said, investors in frontier markets have made significant losses over the past decade. While the potential rewards are high, so are the risks. Frontier markets tend to have poorer levels of corporate governance and more prevalent corruption. An immature economic and political backdrop means they may be prone to war, civil unrest and political upheaval – highly disruptive events that can cause even high-quality stocks to underperform. As Delic points out, while the World Bank’s median ranking of emerging market countries for protecting minority investors is 37th, frontier markets are ranked 72nd – they are clearly the riskier option.
“Investing in frontier markets is not for the fainthearted,” says Alex Moore, head of collectives research at Rathbones. “These markets are typically very vulnerable to social, macroeconomic and political turbulence.”
He says some investors use themas part of a core-satellite approach, where a focused frontier market opportunity is added to a core emerging market exposure. One reason for adopting this approach is that the big eight emerging markets dominate their regions, so they tend to become the focus of regional funds and indices. China, for example, makes up 33% of the MSCI Emerging Markets index. As a result, investors who use mainstream emerging markets indices can sometimes end up with overly concentrated portfolios.
Lands of opportunity
In contrast, frontier markets get little attention. “This means our opportunity to add alpha is great,” says Vecht. “Whenever people ask me, ‘I have $100 – which country should I put it in?’, I say that’s not the right question. We are big believers in not focusing on one country, but instead investing in a collection of diverse countries.”
Over the past year, he has added to his holdings in Pakistan, and he sees opportunities in Thailand, Saudi Arabia and Egypt. Vecht’s diversification strategy of having “a meaningful weighting in lots of different countries” is illustrated by the trust’s 3% investment in each of 13 countries and its 2% exposure in a further 19 countries. The BlackRock Frontiers trust returned 11% over three years and 51% over five years to 7 January 2020.
Frontier markets have fewer financial links globally and their broad geographic spread means they are barely intertwined. Nick Eisinger, portfolio manager of the Vanguard Emerging Markets Bond fund, says: “Frontier markets are able to provide diversification, as much of the risk is idiosyncratic so they can behave differently from broader emerging markets.”
Moore says it’s crucial to know the market and to be prepared for bouts of sizeable volatility while investing for the long term – one or two decades. Volatility can be quite dramatic. Romanian stocks, for example, have been particularly volatile over the past year, says Julian Zsar, a product specialist in the emerging market equities team a Pictet Asset Management. The market fell by 25% between December 2018 and January 2019, only to recover and become a top-performing frontier and emerging market in 2019. It rose in value by almost 40% from January to the end of November 2019.
Vecht points out that individual frontier countries are highly volatile, but also that “when you have a portfolio of them, they are less volatile than the FTSE 100, because they have no correlation with one other”. He adds: “When Argentina collapses, that tells you nothing about what Nigeria is going to do.” It’s not the same with emerging markets.
Neither emerging nor frontier markets have done particularly well over the past decade. The MSCI Emerging Markets index returned about 8.5%, while the MSCI Frontier Markets index returned 12%. Over the same period, the S&P 500 tripled in value.
“People haven’t been looking at frontier markets because there is less liquidity there,” says Vecht. But he argues that markets will reconnect, as earnings “have been growing nicely”. They offer “cheap valuations, solid growth potential and good yields in a yield-starved world”. He adds: “When people are cautious, perhaps one can take great advantage.”
One part of the frontier segment Zsar is finding interesting today is frontier Europe. The Pictet Emerging Europe fund holds numerous positions across Slovenia, Romania and Kazakhstan. He adds: “These are relatively underdeveloped equity markets: the ratios of market capitalisation to GDP are significantly lower than those in the emerging world.”
Zsar says that across these markets the investible universe tends to be heavily skewed towards financials and energy. The volatility in Romania, for example, can stem from heavy-handed fiscal intervention in the banking and energy sectors. He adds: “When such political risks exist, we are happy to stay on the sidelines, and invest where we have higher conviction and capacity to forecast fundamentals.”
In Kazahkstan and Slovenia the picture is very different. “These are economies with stable GDP growth, controlled inflation and highly profitable banks,” says Zsar. He has holdings in Halyk Bank, Kazakhstan’s largest bank, and in Slovenian bank Nova Ljubjanska Banka. Both banks trade at attractive price-to-book ratios and are expected to pay out decent dividends. The Pictet Emerging Europe fund returned 32% over the three years to 7 January 2020.
Investors who want to tap into such growth stories don’t need to invest directly. Many developed world firms that address long-term challenges – for example, through solar power, battery technology or water irrigation – also tap into frontier markets.
Jordan Sriharan, head of managed portfolios and passives at Canaccord GenuityWealth Management, says: “Businesses that can sell directly into emerging markets don’t always need to be sourced from emerging market capital markets.”
MSCI emerging and frontier market indices coverage
|MSCI Frontier Markets Index|
|Americas||Europe, Middle East
|Asia||Europe and CIS||Africa||Middle East||Asia|
|Peru||Qatar||Pakistan||Serbia||West African Economic and Monetary Union|
|United Arab Emirates|
Note: *Economic and Monetary Union. Source: MSCI