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Frontier markets are like promising athletes: catch them young and watch them grow. Glibness aside, these investment options are increasingly attracting forward-thinking managers and investors looking for new opportunities.

There is no clear definition of a “frontier” market, but they are widely classified as a sub-set of emerging markets with attractive investment options relative to the BRIC alternatives. The New York-based index provider MSCI Barra has broadly identified 26 countries in Asia, Eastern Europe, the Middle East and the Americas as such.

As the Canadian economy continues its recovery from one of the most devastating global recessions in history, risk appetites are returning. Interest is gathering in small, exotic and often illiquid frontiers markets. Slowing growth rates in India and China are further prompting managers to turn to frontier economies in their quest for the next high-growth markets.

Predicting which market the money will flow into is not easy. Expert opinions can vary depending on individual understanding, interests and the parameters applied.

Kevin Eng, portfolio analyst at Russell Investments in Toronto, says money will stream to more liquid countries, and he identifies Nigeria, Sri Lanka and Kenya as likely beneficiaries.

“In general, those frontier markets trading at compelling valuations and possess solid economic/financial health and have companies that are capable of delivering robust earnings growth will most likely be the beneficiaries of inflows,” says Eng.

Many other managers, however, point to the Middle East and North Africa—the so-called MENA markets—as the best bets for rapid growth.

“The most liquid frontier markets are those in MENA and most frontier money will flow to these markets — in particular, UAE, Qatar, Kuwait and Saudi Arabia,” says Phil Langham, head of Global Emerging Markets at RBC Global Asset Management. “Nigeria is the only other investable frontier market in Africa.” He says other than these, the liquidity is poor.

Andrea Nannini, manager of HSBC Middle East North Africa (MENA) fund, agrees.

“The MENA region currently offers a very attractive investment proposition,” says Nannini. The region enjoys a rich spread of influential factors. “Population demographics are supportive to economic growth, with a predominance of young people, who in turn fund consumption.”

She identifies a higher level of commodity prices, pro-active government policies, and significant infrastructure spending as other positives that add to the region’s overall appeal.

Frontier markets are the new emerging markets, especially in the MENA region, says Rayan Salam, Dubai-based portfolio manager for Algebra Capital, a firm that manages the Franklin Templeton MENA Fund for Canadians.

Salam’s list of potential frontier markets includes Gulf Cooperation Council (GCC) countries such as the UAE, Saudi Arabia, Kuwait, Qatar, Oman and Bahrain. Egypt, Tunisia and Morocco in North Africa are other potential markets.

“The money will flow to the MENA region because of its size within the frontier markets and [the region’s] robust government surpluses. These are very wealthy countries and their ability to grow and expand is much higher than other frontier markets,” says Salam.

So what exactly makes frontier markets an attractive alternative to emerging markets?

“The most commonly used reasons are that they are undiscovered, under-owned, uncorrelated with other global markets, have low volatility and have historically performed well,” says Phil Langham, head of Global Emerging Markets at RBC Global Asset Management.

Eng offers a closer view.

“They are a good diversifier to existing portfolios. They are high-potential alpha source—under-researched and under-owned by foreign investors,” says Eng. Many undervalued companies, underdeveloped equity markets with low market cap/GDP ratios, and resources are some of the other compelling factors for investors to consider, he says.

The rich spread of its influential factors also includes economic growth fuelled by population demographics and potential growth in credit and financial markets.

“Also, as liquidity improves, more investors will be willing to participate in the market,” says Eng.

Langham, however, puts the brakes on the gushing tide of frontier market positives, balancing his optimism with a cold touch of market reality.

“This needs to be put into context,” he says. “Flows to frontier markets over the last few years have increased but from an incredibly low base, and represent a fraction of flows to emerging markets overall.”

Langham says investment flows generally follow performance.

“We saw strong inflows into MENA funds in 2007 and early 2008, followed by a significant outflow,” he says. Flows have since stabilized and are not increasing.

The relatively young and undervalued frontier markets also have their fair share of risks in their performance portfolio. Volatility, inflation, political instability and restrictions to overseas investors are some of the biggest hurdles.

“The degree of correlation to commodities offers a degree of risk,” says Nannini. “Geopolitical risk is another factor to consider, alongside transparency and governance issues.”

She says that though there have been improvements in recent years, they are still trailing behind those of the more developed emerging markets.

Langham is more concerned by low liquidity. “These markets are considerably less liquid than emerging markets,” he says. “It is also important when investing in these markets to be in a diversified portfolio by country so as to reduce country-specific political and economic risk.”

He says a correction in crude would be a risk, in an obvious reference to markets with large exposure to commodities and oil such as those in the Middle East.

Rising protectionism and capital control, inadequate fiscal or monetary policies, and high investing costs are some of the other pains that must be endured for better gains.

This brings up the million dollar question: Is there ample reward for these increased risks? Opinions are bullish but they come with caveats.

“The high returns are usually the result of a country’s higher growth potential, while their high risk is a reflection of their political and economic instability,” says Eng. “Frontier markets offer a wider range of returns than, say, developed markets, but with added risk comes the potential for greater return.”

He says exposure to frontier markets should be seen as part of the diversification benefit within a total portfolio context.

Langham thinks it would be wrong to assume guaranteed high returns.

“I don’t think that the investment case for many of these markets will be as high as for emerging markets,” he says. “Interestingly, however, from my point of view a very powerful reason for owning frontier markets is that they aren’t that risky if a diversified portfolio is taken.”

For example, being invested strictly in the MENA markets would be risky.

“Volatility for a diversified portfolio of frontier markets has historically been low and, other than in real crisis situations, these markets show a low correlation with other asset classes.”

(05/04/10)

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Originally published on Advisor.ca