It has been a good period for frontier markets, but Advance Emerging Capital’s CIO Slim Feriani warns that accessing these fast growing economies through exchange-traded funds (ETFs) could turn ‘ugly’ for investors.
It is easy to see frontier markets’ appeal. Over the past three years, the MSCI Frontier Markets index has gained an annualised 4.34% while the MSCI Emerging Markets index lost an annualised 3.35% through the same period.
One reason commonly advanced for their relative success is that they represent young, dynamic economies currently in a similar position to the emerging markets of the early 2000s. A separate advantage of late has been the tendency of frontier market currencies to be pegged to the dollar, so dips have not been exacerbated for UK and US investors.
The markets are also held to be more diverse and less correlated, both with each other and with different markets, and so less reliant on Chinese growth, than the more mature emerging economies.
This is evident in the sector composition of the MSCI Frontier Markets index: 54% of it is in financials, which at this level are predominantly domestic plays, compared with 26% of the MSCI Emerging Markets index. The next largest component of the frontier markets, at 14%, is the similarly domestic telecoms industry. It comprises just 7% of the emerging markets index, where more globally dependent IT businesses are in second place with 17%.
If frontier markets are to emulate the surge achieved by emerging markets at the equivalent point in their development, it would be fair to presume that tapping that beta passively would be the best option.
The experience of emerging market investors would appear to bear that out. On a 10-year view, the MSCI Emerging Market index has returned 198%; the average fund in Citywire’s Global Emerging Markets sector produced 178%. Over five years, active funds lag too with 70% to the index’s 78%.
But Feriani says accessing frontier markets through ETFs could turn ugly. While he accepts that ETFs have a valid role in liquid markets, he warns that the passive approach is far more risky for illiquid assets.
And frontier markets are considerably smaller and less liquid than even emerging ones. The MSCI Emerging Markets index contains 822 constituents, with a median market capitalisation of £1.3 billion. The equivalent numbers for the MSCI Frontier Markets index are 143 names with an average size of £377 million.
Feriani adds an ethical dimension to his case against frontier ETFs as well. He argues that by embracing ‘hot money’, which flies in and out of markets on investor whim, ETFs increase the volatility of frontier markets whereas active managers tend to take stable longer-term positions.
‘On a global macroeconomic level, that is a much more responsible method of the developed world providing finance to the wider developing markets,’ he said.