Adam Ant sang about the kings of the wild frontier. For most equity investors, however, frontier markets sound too wild for comfort.
And indeed, some of these markets are heavily exposed to specific risks. Tony Lawrence, investment manager at Seven Investment Management, cites the possibility of military-driven regime changes and currency devaluations as two striking examples.
But, for Lawrence, these markets are being unfairly overlooked. ‘There is a difference between the perception and the reality,’ he said. Additionally, he pointed out how country diversification and active management can mitigate country specific risks.
So what, exactly, are frontier markets? Xavier Hovasse, Citywire + rated head of emerging markets at Carmignac, said there are many different definitions. MSCI, however, has its own definition.
The MSCI website currently lists 22 eligible countries, mainly across Europe/Commonwealth of Independent States, Africa and the Middle East. The top five country weightings at the end of August are shown in chart 1 (below).
For Hovasse, however, the concept of frontier markets as an asset class does not make much sense because it hides huge disparities. He points out that Kuwait, for example, is very rich, while Kenya is very poor. ‘So you can’t have one single view on these markets,’ he said. ‘They all have their own internal issues and dynamics.’
But frontier markets throw up interesting country-specific investment opportunities. ‘They offer good diversification benefits, as they have individual idiosyncratic features,’ said Hovasse.
He cites Argentina as a notable example. It is the MSCI Frontier Markets Index’s largest constituent, at 20.4%, and the sole Americas’ representative.
‘We have a significant exposure to Argentina,’ said Hovasse, ‘because it is relatively uncorrelated to the rest of the world.’ He explained this is because it defaulted on its debt in 2001 and was cut off from the world from 2001 to 2015.
‘The country had legacy sovereign debt that was rolled over,’ said Hovasse. ‘But now the economic recovery is well under way and the country has its own growth dynamics.’
Meanwhile, Charles Sunnucks, assistant manager of the Jupiter Emerging and Frontier Income Trust, points out the demographic tailwinds of some African nations. ‘The median age in Nigeria is 18,’ he said; ‘in Kenya, it is around 20.’
Additionally, Dominic Bokor-Ingram, manager of the Charlemagne Magna New Frontiers fund, notes some frontier markets benefit from being in the early stages of reform processes. ‘These are more driven by domestic factors than global factors,’ he said.
Hovasse predicted Vietnam to have higher growth than China over the next 10 to 15 years. He expects Argentina to do the same against Brazil; the same goes for Sri Lanka versus India.
Frontier markets also throw up company specific alpha opportunities. Companies in these countries are under-researched and under-owned by Western investors. ‘This creates huge opportunities,’ said Lawrence. Bokor-Ingram indicated that, while emerging markets are 50% foreign-owned, the figure is just 5% for frontier markets.
Sunnucks highlights three particular stock opportunities: Kenya Commercial Bank (KCB), Vietnam Dairy Products and Pakistani banks in general. He pointed out the Kenyan bank, with its long history in the country, is very profitable. Kenya has around 25,000 mortgages in a population of around 48 million, so he sees many prospects for the company.
He thinks Vietnam Dairy Products can benefit from structural growth opportunities, pointing out per capita milk consumption is limited, even when compared with emerging markets such as China. It is a fast-growing market and health concerns mean consumers want a good branded product when purchasing milk.
Sunnucks believes there is a strong opportunity for Pakistani banks, despite political uncertainties. ‘Only around 13% of Pakistani adults have bank accounts,’ he said. ‘Of this, only 14% are women.’ He emphasised Pakistan’s low corporate debt to gross domestic product (GDP), even when compared with other emerging markets.
Furthermore, Lawrence sees a valuation opportunity in frontier markets. He pointed out similar companies in similar stages of development, with similar growth profiles from other parts of the world, may be on double the valuations.
Even so, there may be good reasons for the lower valuations of frontier market stocks. These markets can be subject to higher political risk than developed markets. Plus, they have lower corporate governance standards.
Frontier markets can also be subject to swings in capital inflows and outflows. In 2015 and 2016, for example, these markets sold off heavily. Lawrence said: ‘Some of these markets are illiquid and it can be hard to get out if everyone rushes through the door at the same time.’
Despite this, Lawrence thinks there are no current signs of excessive buying into frontier markets. ‘It’s a risk we’re willing to take,’ he said.
Another concern is the volatility of these markets, which can be very high. As the table (below) shows, in the past three years Argentina and Nigeria have annualised volatilities of 36.3% and 34.7%, respectively, compared with just 11.8% for the US.
However, the table also shows the volatility of frontier markets as a whole, at 12.2%, is comparable with that of world developed markets, at 12.1%. This perhaps surprising outcome is down to the fact individual frontier markets can be relatively uncorrelated with each other.
Bangladesh, for example, has a correlation of -0.11 with Croatia (a coefficient of 1 means a perfect positive correlation, while a figure of -1 reflects a perfect negative correlation). Meanwhile, Nigeria has a correlation of precisely zero with the Lebanon.
Moreover, as the table shows, frontier markets as a whole are relatively uncorrelated with world developed markets. So, the US, UK and Europe have correlations with world developed market equities of 0.93, 0.82 and 0.81, respectively.
But frontier markets have a correlation coefficient of just 0.5 with world developed markets. This suggests frontier markets can make excellent geographical diversifiers.
Holding the frontier
Lawrence thinks several factors are driving this low correlation. First is the relative lack of foreign investment alluded to earlier in this article. Second, frontier countries generally have low debt at the governmental, corporate and household levels and so are less correlated with global currency and interest rate movements.
In addition, Lawrence thinks the fact it is hard to invest passively in frontier markets makes them less sensitive to big global risk-on/risk-off moves. ‘Frontier markets barely skipped a heartbeat to heightened North Korea tensions,’ he said.
Indeed, the only frontier markets passive fund currently available to UK investors is the US dollar-denominated iShares MSCI Frontier 100 ETF (exchange-traded fund). As chart 2 (below) shows, in the past five years it has had significant tracking error against its MSCI Frontier Markets 100 benchmark in sterling terms. This seems to show the difficulty of tracking these relatively illiquid markets.
By contrast, chart 3 (below) shows the average frontier markets equity manager lags only slightly behind the MSCI Frontier Markets benchmark. The chart also shows that, for significant periods in the past five years, the average manager has outperformed the benchmark.
It is small wonder that Lawrence is a keen advocate of active fund management in these markets. ‘It is the place to find alpha,’ he said. ‘It is uncovered by analysts and managers must do the legwork themselves. So the charges are slightly higher, but it’s a price worth paying.’
Bokor-Ingram added there is a much higher dispersion between the best and worst-performing frontier markets than there is within emerging markets and developed markets. ‘This gives greater stock picking opportunities for active managers,’ he said.
Moreover, he stressed that many frontier market stocks are listed on developed stock markets. ‘Georgia has three companies listed in London,’ he said. ‘We can buy these, but passives can’t.’
Lawrence also pointed out active management can be a defence against poorer corporate governance. Moreover, he said active managers can go off benchmark and allocate to countries less represented in the index. Indeed, the dominance of Argentina and Kuwait in chart 1 shows the index is significantly exposed to country specific risks.
What is more, the MSCI Frontier Markets Index is also exposed to sector specific risks, which can be addressed by active fund managers. Most notably, financials comprise 45.2% of the index’s sector weightings.
A mixed bag
So should you take the plunge and hold dedicated frontier markets funds in your portfolios? There is no simple answer here, but Lawrence thinks there is a case for doing so.
‘We have allocations to all major geographical regions: Europe, the US, emerging markets and frontier markets,’ he said. ‘A dedicated frontier markets fund allows a more targeted asset allocation for our multi-asset funds.’
But Hovasse said he is not promoting frontier markets as a whole, and highlighted the importance of being selective. ‘Lots of frontier markets are unattractive today,’ he said. ‘The Middle East and Nigeria depend significantly on oil, but oil is not the energy of the future.’
Sunnucks, meanwhile, said it is hard to justify running an explicitly frontier markets fund. ‘Frontier markets are better managed within a wider emerging markets fund,’ he said. ‘If we held lots of frontier markets banks, we might have less emerging markets banks. So a wider fund helps manage risks.’
Shot in the dark
While risk has been a repeated theme in this article, it is worth noting the developed world today is not without significant risks itself. The unpredictability of US president Donald Trump and uncertainties over Brexit are cases in point.
Perhaps, then, we can look more favourably at frontier markets that offer diversification benefits and opportunities for alpha. They may even stand and deliver.