Seeking new investment frontiers

Following two decades of strong economic growth and infrastructure improvements, emerging markets have now become a mainstream asset class with a key role in investors’ portfolios. While leading countries such as China, India, Brazil and Russia (Bric) continue to be appealing, the attention has started to shift to so-called frontier markets. Often referred to as the emerging markets of the future, these smaller, fast growing markets offer attractive long-term prospects, but they are relatively new capital markets at an early stage of development, illiquid, with low levels of foreign ownership and still under-researched.

Frontier markets are driven by similar factors that drive emerging markets growth, such as positive demographics and growing infrastructure spending, says Andrea Nannini, senior portfolio manager of the frontier emerging markets and Mena equities at HSCB Global Asset Management. They are often rich in commodities, and the domestic consumption theme, dominant in countries such as China and India, is also significant in markets such as Nigeria, Egypt and Lebanon.

“In frontier markets you are investing in trends similar to those in emerging markets, but at a much earlier stage of the cycle, as if investing in the Brics maybe 10-15 years ago,” says Mr Nannini. “The opportunities in the longer term are bigger, because you are starting at an earlier point of development, but the flip side is that you have bigger risks too.”

These are mainly event risks, such as political, regulatory or market specific risks, although, says Mr Nannini, these can be managed in a well diversified portfolio, having exposure to many different markets.

It is counterintuitive, but in fact the volatility and correlation between frontier markets is lower than in emerging markets on the longer term. Individual frontier countries can be volatile, but as the correlation between each other is quite low and often negative, as they are all mainly driven by local factors, rather than global factors, the volatility of the whole group tends to be smaller. On the contrary, there is a growing tendency for larger developing markets to move in sync with each other, which increases their volatility, says Mr Nannini. However, in big market shocks, such as in 2008, frontier markets tend to suffer most, because they are less liquid, and price corrections are exacerbated by the lack of liquidity. For example in the last five months of 2008, frontier markets fell on average between 50 to 60 per cent.

Issues of their own

In 2009, while emerging markets had a very strong recovery with 60-70 per cent returns, frontier markets did not participate in the rally, growing by 11 per cent on average. This was because they were facing issues of their own, including Dubai’s debt problems and the Nigerian banking crisis.

“Today, frontier markets are still trading roughly 40 or 50 per cent lower than their pre-crisis levels in 2008, whereas emerging markets are pretty much back at the peak levels. We think there is potential for frontier market markets to continue their recovery,” says Mr Nannini.

In developing capital markets, foreign investments can really have a large impact on market performance. But in 2009, the big foreign inflows went back to emerging markets mainly, which generated stellar returns. “Frontier markets are small, still relatively new and little understood, and when the market starts recovering, usually the largest markets, such as Brics, and the largest stocks do best at first. As people feel the value is maturing, which is probably where we are now, the focus starts shifting towards mid or small caps, and the more exotic stories like frontier markets,” says Mr Nannini.

The United Arab Emirates and Nigeria present particular value today. Mena stockmarkets are still suffering in the aftermath of the Dubai debt crisis, even though the restructuring of the Dubai World, the investment company that manages and supervises a portfolio of businesses and projects for the Dubai government, was agreed in September, and the Dubai government has successfully completed its first debt issue since the crisis. This is a sure sign that the capital markets are opening up, but the stock market has not yet priced this in.

“The markets in Dubai and Abu Dhabi are by far the cheapest in the world,” he says. UAE are the largest overweight in Mr Nannini’s Mena fund, while in his new frontier market fund, the largest country overweight is Nigeria, which still appears to be trading at an attractive valuation level in the wake of the banking crisis, he states.

Nigeria is a fast growing economy, maintaining GDP growth of around 5 per cent throughout the crisis. Repercussions from the banking crisis meant that the market produced negative returns in 2009, and although it has been one of the best performing markets so far in 2010, it is still below 2008 levels.

Emily Whiting, JP Morgan

Markets classified as frontier by index providers are excluded by the traditional emerging market indices, because they are illiquid and generally difficulty to access. FTSE, MSCI and Standard & Poor’s have created dedicated frontier market indices, which comprise 20 to 30 countries spanning five regions, although the Gulf States represent by far the highest weights. There are no set criteria that allow to establish whether or when these frontier markets will ever graduate to emerging markets. The case of Argentina – which last year MSCI downgraded to frontier market from emerging market, because of its restrictions to in- and outflows of capital in its equity markets – shows that decision is still very much at the discretion of index providers.

Some of these frontier markets are going to be confined to this category, says Andrzej Blachut, head of emerging markets at Swiss & Global Asset Management. Countries in the Baltic region, despite being part of the European Union, are too small in terms of market capitalisation. Others, such as Kazakhstan and Nigeria, have great opportunities to make the next step and Argentina too will probably be promoted back to emerging market, once it lifts capital controls.

The Black Sea region which was hit hard during the financial crisis, has the potential to stage a fast recovery, according to Mr Blachut. With one of the lowest relative valuations in history, easy access to commodities and low labour costs, the region has a strong competitive advantage. Kazakhstan is one of the main source of commodity for China and it represents a big overweigh in Swiss & Global’s fund, while Mongolia also shows interesting opportunities. The fund also invests also in Russia, in smaller stocks. “Building portfolios only on frontier markets is a little bit too risky. Usually 30 to 50 per cent of the fund is invested in liquid assets, with the remainder invested in frontier markets, where often liquidity is very low,” he says.

Nigeria, “the Brazil of the future,” according to Mr Blachut, is the focus of the firm’s Northern Africa fund, which also invests in some of the smaller emerging markets like Egypt and Morocco, and in other frontier markets like Tunisia and Kenia.

About 30 per cent of the Nigerian’s GDP is related to oil production, and the oil price increase in the past 12-18 months has greatly improved the financial situation of the economy. The consumer or infrastructure related sectors, like cement producers, offer attractive buying opportunities. The banking sector crisis was the main reason why Nigeria did not perform in 2009, but this problem is cleaned, and bank loans are growing. For the African country, the most important test will be the upcoming presidential elections in 2011, he says.

Rather than being drawn by how index providers grade different markets, it is important to look for the best ideas in the investment universe, explains Emily Whiting, client portfolio manager at JP Morgan Asset Management.

“The main frontier markets are Argentina and Nigeria, and maybe Kazakhstan. We feel these countries have good companies, with the liquidity that we need,” she says. “We are always keen not to shut the door on any potential investment just because of the country they are in, or the state of the wider economy. For example, when Argentina got downgraded, we still held one of our Argentinean stocks in some of our emerging market funds, because we still felt it was a very good company to be invested in.”

JP Morgan runs an African fund, which is believed to offer a stronger investment opportunity as frontier markets and more liquidity. The fund tends to focus on the more developed parts of the continent, such as South Africa, as well as Egypt and Morocco, but many companies, such as mobile phone providers listed in South Africa, participate across wider Africa, says Ms Whiting.

A common characteristic across all frontier markets is that governments and politicians have tried to learn from the mistakes of developed market politicians and economies. “Frontier markets are not looking for short-term boost as they might have done a few years ago, but they are looking to really keep things moving long-term in the right direction and understand what it takes to make a sustainable economy,” she says.

There are very valid reasons to invest in both emerging markets and frontier markets, but it all depends on the risk profile of the investor and how long they are willing to have their money tied up and suffer set backs, she says.

Developing markets are volatile so investors should not try and time them; frontier markets especially are very long term theme. “We would suggest a 10 year investment horizon for frontier markets, as the direction of the growth is quite evident over the longer term.” The general recommended allocation to emerging markets is 10 per cent, she says, but very rarely are frontier markets mentioned.

The African story

Where the opportunity lies in Africa is in the increase in consuming spending power of the population, explains Nicolas Clavel, chief investment officer at Africa-focussed asset manager Scipion Capital. With a population of around 1bn people, by 2020 there will be 128m consumers in Africa with discretionary spending power. By 2040, there will be as many consumers in Africa as there are in China today, says Mr Clavel.

That Africa is the poorest continent in the world is a question of perception, he says. “There are more families with $20,000 (€15,000) income per year in Africa than there are in India today. The African continent has seen massive improvements over the last 10 years, in the infrastructure, in the ability of people to make money and to communicate, he says. “Mobile telephone internet is really making the continent progress leap and bounce.”

The development of mobile phone banking is providing a massive help for salary earners in towns to send money back remotely to their family in rural areas, and it is created a whole new banking system, designed for very low-income users that have long been under-served or ignored by traditional banks.

“Our strategy has been to be very bullish on the sectors that will benefit from that growth, and sectors that you can actually invest in. Number one is the cement industry, because people build their own houses, and you see that when you travel across the continent. Drink manufacturers, breweries, are the second beneficiaries. The third is the telecoms/internet industry.” Two massive undersea cables have been now completed across the continent, which have increased the speed of access to the internet to a level that is competitive with the rest of the world, says Mr Clavel.

The firm’s flagship fund, a commodity trade finance fund, focuses on the copper belt countries such as Zambia, Tanzania, Malawi, or Congo, whereas its passive product, an exchange traded fund (ETF), is claimed to be the first pan-African index tracker. The firm also offers an actively managed equity fund.

The African story is based on the assumption that Asia and Latin America will be the main drivers of global growth and that their rising demand of commodities will benefit all commodity-rich regions, including Africa, says Véronique Riches-Flores, head of thematic research at Société Générale Corporate & Investment Banking.

The demand for global energy, fuel and soft commodities is estimated to rise by probably 90 to 120 in the next two decades. Africa has a huge potential to develop solar industry and the Desertec project, proposed by the homonymous foundation for making use of solar energy and wind energy in the deserts worldwide, will help to develop this industry in the Northern part of Africa, she says.

After a very long period of poverty and extremely weak growth, in the past 10 years Africa has begun to put in place the foundations for economic development. Exports of commodity production have greatly increased, in particular towards Asia and commodities have also been a driver of foreign investments, in particular from China, and other emerging markets. Foreign investments are also focusing on the development of the agricultural sector. There are widespread concerns over the possibility that foreign investments may exploit the continent resources, without benefiting the local people. Ms Riches-Flores believes that the net result for Africa will be positive, and that the flow of investments is driving faster economic development.

Economic progress has been accompanied by urban development – 40 per cent of the population now live in cities – and the emergence of a middle class. Demographic transition is also happening, and the proportion of young adults is growing very fast when compared to the overall population, because the death rate has reduced, while the fertility ratio has fallen substantially. There is still a very high degree of corruption and bad governance, especially in the Central Africa area, but the region is taking off.

It is not just South Africa that participates most in these changes. Countries such as Nigeria, Angola, Egypt, Sudan and Morocco are driving economic growth, she says.

African capital markets are still extremely limited with poor liquidity, although they are expanding rapidly, and South African stock exchanges represent close to 85 per cent of the region’s market cap.

The most effective way to invest in the continent is through European or foreign companies that have a presence in Africa. Société Générale has put together a basket of 16 European stocks, which are the most exposed to the main five African themes; natural resources, alternative energy sector, water resources, infrastructure and consumption, which is related to the sharp increase of middle class and urbanisation. Investing in European stocks, rather than local stocks, may generate lower returns, but they provide much easier access. Also a number of sectors are not well represented by local companies, such as utilities, for example, explains Ms Riches-Flores, and investing in local firms is more risky, because of lower transparency and general instability.

South Africa is the most important country in the Civets group of six countries (Colombia, Indonesia, Vietnam, Egypt, Turkey and South Africa), which are hailed as the new Brics. These countries, which have each large, young, growing populations, diverse and dynamic economies, and, in relative terms, are politically stable, are the new emerging market growth stories to watch in the next few years.

Investable indices

Stock-picking may even more important in frontier markets, because they are small markets. Indices have limited scope, and they are not fully representative of the trends driving the economic growth, and the most interesting investment prospects in frontier markets can be found outside the indices. But passive products, such as ETFs, are also gaining popularity. “ETFs do not necessarily compete with active funds, but offer a liquid and cheap solution to gain immediate access to those markets. They can be used as building blocks as long term investments or for tactical investing” says Manooj Mistry, head of db x-trackers ETFs UK.

To meet client demand, db x-trackers launched two frontier markets ETFs in 2008, one tracking the S&P Select Frontier ETF and the other the FTSE Vietnam, both unique in Europe. The number of constituents in the broader indices offered by the two providers was narrowed down to the most liquid and the ones which are the most accessible, explains Mr Mistry.

The Vietnam ETF has gathered over $250m while the S&P Select frontier ETF, which covers a number of frontier market countries and it is composed of 40 of the most liquid stocks, has raised $40m. “We see quite a lot of small size transactions in these ETFs as well, which indicate that retail investors are also using them,” he says.

After launching individual ETFs for the established emerging markets, the firm has broadened its product range with exchange traded funds tracking smaller emerging markets such like Indonesia, Malaysia and Thailand. But it is hard to create and investable index for proper frontier markets, which remain difficult to track. “The frontier markets are still a niche area, it is the more established emerging markets that have attracted the better flows,” he says, explaining that strong inflows this year have been into their broad MSCI emerging market ETF and into India, China and Russia ETFs.