Investors have made inroads into emerging markets—but there’s another market just off the trail

Investors are always looking for the next big thing—and frontier markets might be it. The fact that the past few years have been kind to these markets doesn’t hurt, either.

For the 12 months ending Aug. 31, 2014, the MSCI Frontier Markets Index has jumped 34%. And, over the past three years, it’s produced an annualized return of 16.1% versus 4.7% for the MSCI Emerging Markets Index.

There are two key reasons why frontier markets are appealing to investors: they have good economic fundamentals, and they provide an opportunity to diversify an equity portfolio.

A Fistful of Dollars
Frontier markets are at a far earlier stage in their evolution and development than emerging markets (from both a financial and a capital markets perspective). “Frontier markets are probably where emerging markets were 20 to 25 years ago,” says Eric Léveillé, managing director and head of the Canadian institutional business with BlackRock Asset Management Canada Ltd.

One of the advantages that frontier market countries have is a strong demographic trend. Between now and 2050, the Harvard School of Public Health predicts the planet’s population will grow by 2.3 billion. About 97% of that increase will be in less developed regions; in developed countries, the population growth will be mostly stagnant.

The developed world is also aging rapidly. In Japan and Germany, just 13% of the population is under age 15. In some frontier market countries, the proportion can be four times as much. For example, 44% of Nigerians and 42% of Kenyans are 15 or younger.

As the population of frontier market countries grows, so, too, will the working- age population. That will give more people disposable income, which should propel economic growth. The International Monetary Fund predicts that both emerging and developing markets economies will grow by 4.6% this year and 5.2% in 2015. Developed market economies are expected to grow by 1.8% in 2014 and 2.4% next year.

When looking at the economic growth rates of frontier markets, what’s important isn’t just how high they are, but also their low base—which means they’re more sustainable, explains LGM Investments’ frontier co-portfolio manager Dafydd Lewis in London.

“Many of these economies are likely to have premium growth rates for one to two decades,” says Michael Levy, portfolio manager, EMEA (Europe, the Middle East and Africa) and frontier markets, with London-based Baring Asset Management.

While high GDP growth doesn’t necessarily translate into equity market performance, it gives corporations the opportunity to exploit growth, he adds. And Levy expects well-managed companies will be in a position to take this strong GDP growth rate and benefit from this trend.

Frontier markets are also in a stronger fiscal position than their counterparts in developed markets, according to the World Bank. The debt-to-GDP ratio for frontier markets is 51% versus 85%. Both Nigeria and Estonia have debt-to-GDP ratios below 15%. The United States’ ratio is nearly 100%; Japan’s is almost 200%.

Happy Trails
Frontier markets also provide an opportunity to diversify an investment portfolio, since the economies in those markets are more localized than emerging markets and not as affected by global factors, such as U.S. monetary policy or economic and political shocks.

“If you contrast that with Taiwan or South Korea in the emerging markets index, or even China, then those are much more integrated into the global economy than sub-Saharan Africa or certain Middle Eastern markets,” explains Iain Douglas, an investment consultant with Towers Watson in New York.

Léveillé agrees that companies in emerging markets have become more global. “For example, if you invest in a global company such as Samsung, do you really get ‘pure’ exposure to an emerging market economy? I don’t think so,” he says. “You get somewhat similar exposure with Samsung than you would with developed economies, while in frontier markets, they’re still truly emerging economies.” When something happens in Vietnam, the likelihood of this nation having an impact in Croatia, for example, is relatively low. They don’t move in tandem, Léveillé adds.

The limited integration with the global economy also makes frontier markets less correlated with other markets. “Many of the economic and capital market linkages that connect more established markets simply don’t exist yet,” according to a report by S&P Capital IQ. Historically, the MSCI Emerging Markets Index has moved in the same direction as the S&P 500 82% of the time while the MSCI Frontier Markets Index has done the same just 55% of the time.

Frontier markets are “a way for institutional investors to add that ‘emergingness’ to their portfolios that no longer really exists in many of the emerging markets today,” adds Lewis, who believes that institutional investors should take a certain percentage of their emerging markets allocation and dedicate it to frontier markets instead.

Rough Ride
While there is a perception that frontier markets are the new emerging markets, as with any investment, there are risks involved. The MSCI Frontier Markets Index is very concentrated and is heavily tilted toward just two countries. Kuwait and Nigeria make up nearly 45% of the index. And three sectors make up 77% of the index, with financials comprising 50% of the total, and telecom and energy making up the other 27%.Trying to make an asset allocation based around that could prove to be challenging, especially if you’re making a passive investment.

Also, as countries within a frontier market mature, they’ll graduate to an emerging markets index (as Qatar and the United Arab Emirates did this year), which could limit growth for a frontier market index.

Liquidity is another issue. A Vanguard report notes that the turnover ratio (the higher the turnover, the better the liquidity) for equities in frontier markets has decreased since 2000 and was lower in 2010 than emerging markets’ turnover level in 1990.

There also aren’t many asset managers specializing in frontier markets investing so there’s a smaller group to choose from, which ultimately results in higher costs. “Fees in active frontier markets investing are terrible,” says Douglas. “You also have the issue that transaction costs are very high.” If investors want exposure to frontier markets, he recommends that they use emerging markets managers and give them the freedom to invest there. Those managers will have experience investing in frontier countries and will also likely cost less.

While many plans haven’t begun to move to the new frontier, demand is expected to pick up in the coming years. And, despite the risks, many investors believe that frontier markets present an attractive opportunity.

“They’re realizing that this asset class has growth, it has diversification characteristics, [and] it’s an area that’s under-discovered,” Levy explains. “Over time, as we saw with emerging markets, you can expect this asset class to grow. You can expect it to go from a niche asset class to a mainstream asset class.”

Don’t Fence Me In
A country may be deemed a frontier market by some index providers and called an emerging market by others. For example, the MSCI and S&P both consider a prosperous country such as Kuwait (with a GDP per capita of US$56,367) as a frontier market while FTSE says it’s an emerging market.

“Some Middle East markets that have historically been included in benchmarks are not really frontier markets,” says LGM Investments’ frontier co-portfolio manager Dafydd Lewis in London, adding that many of them are considered such because of foreign ownership limits or trading restrictions. In contrast, some countries are not included in a frontier index—although they should be—because they don’t have enough listed companies to be included.

But there are countries that all index providers agree are frontier markets, such as Bangladesh (with a GDP per capita of US$750), Kenya (with a GDP per capita of US$933) and Serbia (with a GDP per capita of US$5,294).

Craig Sebastiano is associate editor of BenefitsCanada.com.

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Copyright © 2020 Transcontinental Media G.P. This article first appeared in Benefits Canada.

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