The challenges of frontier markets

Although the term once coined by the International Finance Corporation in 1992 still stirs up fears as well as fantasies among the investor community, frontier markets’ popularity has grown in recent years. There is no doubt that they provide access to some of the fastest growing economies in the world. Their investment potential remains largely untapped and they present numerous competitive advantages, including low labour costs, strong demographics and abundant natural resources.

Seeing frontiers as the new Eldorado of investments would be a bit premature but, as Wayne Gretzky, the ice hockey legend, said: “A good player plays where the puck is, a great player plays where the puck is going to be.”

Sceptics are concerned about the volatility of returns in frontier markets and their true ability to take off and escape poverty. Firstly, these countries are not all ravaged by wars, disease, famine and authoritarian regimes, as is often misrepresented by the media. Many of them have undergone a radical restructuring of their economies and are in a better shape than several developed economies.

Secondly, taken individually frontier markets are, on average, more volatile than emerging markets. But take a five-year standard deviation as a reasonable measure of risk, and a whole basket of frontier markets such as the MSCI Frontier Markets might be a much better bet than the MSCI Emerging Markets, with 23.5 per cent versus 28 per cent.

Why such a difference? Frontier economies are often insulated and their companies driven by local demand, resulting in low intra-market correlations. Most potential investors have a pretty good understanding of the benefit of adding frontier markets to an equity allocation, but many still overlook the immense added value of these low intra-market correlations. In order to take full advantage of those characteristics and mitigate the numerous risks of investing in frontier markets, it might be worth considering a diversified basket of frontier companies, markets and even managers.

The number of frontier-market strategies available to investors is growing but remains limited, as is the number of specialists dedicated to the asset class. This has led to a high manager turnover in recent years. The bigger houses tend to allocate only few resources to the asset class and usually rely on the pool of their expertise in emerging markets. Boutiques usually have one experienced manager with a couple of younger analysts.

The other challenge for a fund selector resides in evaluating the ability of the manager to deal with the operational hurdles (lack of liquidity, higher cost of trading and access to some markets) of the frontier market asset class itself and the resulting impact on the investment aspect. Bigger is not always better for managers, especially in asset classes where liquidity is a major consideration.

Some will find the answer to the liquidity question in enhancing their universe with the smallest emerging markets such as Peru, Egypt, or Morocco (the latter will be downgraded to frontier-market status in November 2013 by MSCI). Higher trading costs are sometimes passed on to new investors through an anti-dilution levy. Access to Saudi Arabia is usually gained through participatory notes (P-Notes).

The argument in favour of passive rather than active investing as regards fees, including transaction costs, remains valid. But although track records are still short, there are managers in frontier markets who have been able to outperform indices/ETFs year in year out, all fees included, for the past five years. Moreover ETFs usually focus on the most liquid securities and countries, an approach which does not allow access to the most compelling inefficiencies. It is worth noting that indices have so far been skewed towards the Middle-East region, which does not always give a true representation of growth and income per capita in the frontier markets. Qatar and the UAE, which currently represent around 25 per cent of the MSCI Frontier Markets, will be upgraded to the emerging markets group by May 2014.

At a time when questions are being raised as to whether emerging markets are still truly emerging or whether they are economically decoupled from developed markets, frontier markets could be the answer and their recent growth in popularity could turn out to be not just the latest craze but a more structural trend. But the importance of choosing the right vehicle and manager must not be overlooked by investors seeking to fully benefit from the numerous advantages of the asset class.  

Didier Chan-Voc-Chun, managing director, head of multi-management and fund research, Union Bancaire Privée