Fear of the unknown
In the popular book and television series Game of Thrones, the ‘Wall’ refers to a massive block of ice that separates the civilised world from the dangerous unknown. What lies beyond the Wall invites equal parts dread and fear – not unlike the emotions that frontier markets trigger among most investors. With headlines mostly trumpeting coups, strikes and terror attacks, its no wonder investors don’t look beyond emerging markets for above average returns.
But if it is the long game that matters, then investors could do well by having another look at the frontier market opportunity set. The MSCI Frontier Markets Index was launched in November 2007 and has 25 countries with 142 constituents and a free float adjusted market cap of $142 billion. Many of today’s emerging markets were once frontier markets. There could be enormous upside potential as these nascent markets make the transition to emerging market status. Some of the fear-inducing events mentioned above can trigger political instability and these moments often provide the perfect time to gain exposure to these markets.
The assumption that stomach-churning volatility is part and parcel of frontier market investing has been challenged recently. A recent study by New York-based fund manager LR Global looked at weekly returns for ten years (2004-2013) from 80 different stock exchanges across developed, emerging and frontier markets. The research showed that frontier market volatility (measured by standard deviation) was lower than emerging markets and was sometimes lower than developed markets over certain periods.
This lower volatility could be partly explained by the fact that frontier markets are not exposed to the global ebb and flow of hot money. At the same time, frontier markets are very diverse economies mostly driven by local money. Not only do they have a low correlation with the global market but they also have a very low correlation amongst themselves, offering significant diversification benefits. We believe an active management strategy that takes advantage of the occasional frontier market crisis to initiate positions at reasonable valuations can produce outsized returns over the long run.
New asset class
Frontier markets have now emerged as a credible asset class. While the definition of frontier markets and what countries constitute this group is still a work in progress, its important to take a note of some of the important developments that have taken place in this sphere. Many frontier markets have been working to strengthen their policy-making, reduce red tape and lower trade restrictions. Debt reduction has freed up funds for investments in physical and human capital. Frontier Markets like Nigeria and Vietnam have deepened their financial markets. Countries like Tanzania and Zambia have been able to tap international financing while Mongolia and Kenya have been making efforts to reduce their debt.
While the MSCI Emerging market index was flat in 2013, the MSCI Frontier Market Index was up 26%. As of the end of June 2014, the MSCI Frontier Markets Index was up another 16% prompting even Norway, with the world’s largest sovereign wealth fund ($890 billion), to boost investments in frontier markets. Norway’s sovereign fund is known for making smart long-term bets, which means frontier markets could gain further credibility in the investment community.
With over 1.2 billion people with a median age of 30, frontier markets provide the largest future middle class opportunity. To reduce risk an investor can invest in the local subsidiary of a multinational, for example Nestle Nigeria. Our approach to frontier markets investing remains the same as the one mentioned in The Emerging Markets Handbook. We use the ten-driver model to sort out the strugglers from the standouts. Then we pay special attention to liquidity, corporate governance and valuation before we make an investment. As frontier markets grow and their capital markets become deeper, there will be many opportunities for investors to benefit from this exciting new growth story.
By Pran Tiku CFP & Vikram Kondur CFA
Our comments, opinions and analysis are for informational purposes only and should not be considered individual investment advice or recommendations to invest in any security or to adopt any investment strategy. Markets and economic conditions are subject to rapid change, comments, opinions and analysis are rendered as of the date of the posting and may change without notice. The material is not intended as a complete analysis of every material fact regarding any country, region, market, industry, investment or strategy