How an investor’s portfolio could benefit from allocation towards Frontier Markets and how to access them.
Frontier Market Strategies: For the sake of diversification
What are Frontier Markets?
One of the best performing asset classes year-to-date is Frontier Markets. They represent an interesting combination of politics and economics that resemble Emerging Markets of the late 90's and show huge growth potential. In the investment hierarchy they sit at the bottom, below the Emerging Markets (such as China, India and Russia), while on the top are their developed peers. The classification judgment for frontier countries relies mainly on the early stage of development for their capital markets rather than wealth. Most of those countries are located in the Middle East, Africa, Emerging Europe and Asia. According to MSCI, the world’s biggest index compiler, to be classified as frontier, a country has to have at least two companies worth about $800m each and show some accessibility for foreign ownership. As at the end of June 2019, the combined market value of all Frontier Markets is $715b, which looks very tiny when compared to the $20t worth of Emerging Market stocks.
What are the benefits of investing in Frontier Markets?
There are numerous benefits that investors could enjoy when investing in Frontier Markets; massive growth potential as these economies begin to mature over the next 10+ years and positive demographics are the obvious ones. Countries such as Vietnam grow at an annual GDP rate of more than 6.5% which is one of the fastest in the world. But there are other “perks” such as diversification, which could be viewed as even more beneficial. These countries have relatively limited financial links to the global economic cycle and therefore exhibit very low correlation with almost every other region/asset class.
That also contributes for their low volatility when compared to the VIX Index and could partly cushion a portfolio during market turbulence.
Being highly inefficient and under-researched is another feature of Frontier Markets that gives investors the opportunity set to go ahead and exploit these irregularities before the information is priced in. One of the major investor attractions is to pick a market or company before the crowds arrive from other overbought areas. Moreover, historical valuations look attractive compared to the emerging peers. Over the course of three and ten year periods, Frontier Markets returned 38% and 116% respectively, and those numbers could grow significantly as economies prosper and financial infrastructure develops. As an example, Pakistan’s main index grew at an annual rate of over 25% in the eight years before it was promoted to an Emerging Market at the end of 2016.
Poor governance, reporting standards and corruption are often considered to be the main issues deterring investors in Frontier Markets, although there is strong evidence that proper due diligence and observing the reality on ground could prove that to be wrong. For instance, structural reforms alongside the 25% reduction of public sector wages in Romania led to large infrastructure funding from the European Union, and the country is now one of the fastest growing in Europe. There are many other examples of countries in Asia, Latin America, Eastern Europe and Africa that turned out to be a fantastic reward for the risk taken, so being familiar with a particular market or region in this sector is a huge advantage.
How to gain exposure to Frontier Markets
Getting access to Frontier Markets could be quite a tricky exercise for an individual investor. Foreign trade in these stocks have much lower volumes given the tight restrictions on share ownership. In addition, liquidity and transparency remain serious concerns for the ordinary retail investor. Therefore, the most reasonable way to invest in this market segment is through actively managed funds. By doing so, the investor also benefits from the manager’s expertise in this “difficult to read” subject as well as the active shareholder engagement, which would otherwise be almost impossible.
T. Rowe Price, Frontier Markets Equity
"Oliver Bell has been managing this strategy since its inception in 2014. He has a wealth of experience within the asset class and is being supported by a well-resourced team of investment professionals. The stock selection is based upon fundamental analysis, while also taking into consideration currency and geopolitical risks as well as the overall macroeconomic picture. That result is a diversified portfolio of between 60 to 80 stocks in which the team have high conviction. Regular travel and meetings with both existing and potential holdings is an essential part of the investment and monitoring process. The fund is benchmark unconstrained which significantly broadens the manager’s universe and gives him the opportunity to invest up to 50% outside the MSCI Frontier Markets Index."
The bottom line
Achieving prosperity in these regions can be divided into a three stage process. First, peace is the main component that provides the stability needed for better politics to take root across frontier economies. Second, democracy encourages governments to focus on sensible macro management in order to get re-elected. Third, improving macro fundamentals attracts increasing levels of foreign interest in the economy that results in higher growth.
There are certain sector specific risks that an investor should be aware of such as the lack of liquidity. Individual countries may also be subject to particular risks such as capital controls, debt default or hyperinflation. From a portfolio management perspective, currency risk needs to be cautiously managed as fast depreciation of currency value is not unusual for Frontier and Emerging Markets. Despite the low correlation with almost every other region/asset class, frontiers could potentially underperform in an equity bear market. In addition, although commodity prices are crucial for oil dependent economies such as some Gulf States, the overall impact on Frontier Markets Index is minor.
Overall, investing in Frontier Markets could deliver a lot of benefits but is also associated with a higher degree of risk. Therefore, these strategies may not be suitable for investors with more conservative risk profile and should be viewed as a satellite vehicle used to complement a core portfolio.
All information given including prices, yields and our opinion is correct at the time of publication. Our opinions on investments can change at any time and for our latest view please go to www.share.com. To understand how our Investment research team arrive at their views please read our Investment Research Policy.