Closer look at frontier markets

By Vikram Barhat | March 1, 2011 | Last updated on March 1, 2011
6 min read

Often referred to as poor cousins of emerging markets, frontier markets’ economies have now picked up the same winds of change that triggered a socio-economic avalanche in emerging markets 20 years ago.

Frontier markets today are high on the radar of managers and investors taking flight to the next lot of high-growth markets. Small, exotic and often illiquid, these smaller markets are widely classified as a subset of emerging markets and are steadily moving up the food chain. Index provider MSCI Barra has identified 26 countries in Asia, Eastern Europe, the Middle East and the Americas as such.

Frontier markets are emerging markets with smaller populations and economies than the BRIC, says Bhim D. Asdhir, president and CEO of Mississauga, Ontario-based Excel Funds Management. A leading crusader for smaller economies, he’s invested considerably in small markets in Eastern Europe, Asia and Latin America, and most recently in Egypt.

“They complement emerging markets because they’re in their vicinity, and are resource-rich, people-rich, and they have young populations,” says Asdhir. “With technology and democracy, these countries are getting wealthier.” By Asdhir’s reckoning, frontier markets make up 3.5% of the global market cap, roughly where the emerging markets were two decades ago. Things can only get better from here.

Positive medium term

The ongoing unrest in the Middle East and Africa may have shaken political foundations, but it hasn’t stirred the long-term view experts hold for the region.

“Over the medium term, the outlook for frontier markets is still positive,” says Andrea Nannini, manager of the HSBC GIF Middle East North Africa (MENA) fund. “A lot of the drivers for the asset class and the economies are still intact; we’re talking about a young and fast-growing population.”

Apart from being producers of commodities such as oil and metals, massive infrastructure investments are fuelling the growth across many of these smaller markets. As these markets open their doors to foreign investment, regulatory wheels will keep turning.

“If you look at Africa, the Middle East, and some of the frontier markets in Latin America from equity-markets and capital-markets points of view, many of these markets are relatively undiscovered, small, and still in the process of opening up and introducing regulations [that will put them] at par with the larger emerging markets,” says Nannini.

Paul Mesburis, senior portfolio manager at Excel Funds, agrees. He uses Kuwait to illustrate how closed some smaller markets are. “Its domestic stock market is quite robust, but there are only 15 stocks a non-Kuwaiti investor can buy.”

If the convergence process continues, these markets will become more investible.

“That is why a lot of people look at frontier markets as the emerging markets of the future, really. [They’re] pretty much where many of today’s larger emerging markets were maybe 10 or 15 years ago,” says Mesburis.

Frontier and emerging markets have similar demographics, infrastructure and commodity production — except frontier markets are smaller and less recognized. But that has its own advantages.

“If you look at the behaviour of stock markets in many of the frontier markets, they tend to be less correlated with global markets and the large emerging markets,” says Nannini. “It’s a way to have emerging-market-like exposure in your portfolio without the same degree of synchronized swings you have in the larger markets like the BRIC economies.”

Complementary investments

From a portfolio point of view, frontier markets are a nice add-on to a core group of larger emerging markets. This approach provides some additional diversification and de-correlation benefits. And because these markets are thinly researched and less understood, they tend to suffer from a valuation discount, Nannini points out.

This means an opportunity to capitalize on unrealized and untapped investment potential.

The global economic downturn provides another dimension to the valuation equation. “If you look at the recovery of these markets from the 2008 global financial crisis, obviously it’s been much more muted in these frontier markets, especially in the Middle East and Africa. So we think with a medium-term mindset, there is potential still for further appreciation in equity prices,” says Nannini.

The larger emerging markets, on the other hand, had a strong rebound in 2009 and 2010, and have pretty much recovered the losses from 2008. Mesburis’ market research reveals a similar observation. “The emerging markets were the first markets to come back after the global recession, because they didn’t go through the recession [as much as] the developed world.”

Buying opportunities

Peripheral events such as the Greek debt mess or the political instability in the Middle East do affect a number of markets on a temporary basis. If Mesburis is to be believed, that dark fact is not without a silver lining. “Those [events] truly are buying opportunities for us to average our cost base lower in those markets.”

Asdhir and Mesburis practice what they preach. Until recently, they weren’t interested in Egypt. But the revolution and the associated market plunge were cues for them to take a position. “The Egyptian market went down 25%, so we looked at it from a risk/return perspective. We said, ‘[The drop] looks like it’s going to be resolved, and in the long term, Egypt is going to be much better off without a dictator in place.’ ”

Nannini says frontier markets are a less volatile asset class because not only are they less plugged into what happens in the rest of the world under normal circumstances, but also because they correlate with each other poorly.

“The overall volatility of a diversified group of frontier markets tends to be quite low,” says Nannini. He argues the investment base is mainly local and stocks are mainly driven by local rather than global factors.

Nigel Rendell, senior emerging markets analyst with Royal Bank of Canada Europe, uses South Africa to make a similar point. “South Africa is not immune to events such as the EU debt problem or the political situation in North Africa and the Middle East, but the links are vague and do not appear to have a direct impact on investor activity,” he says. “SA benefits from rising commodity prices, so there are positive side effects.”

Not all rosy

Frontier market prospectuses abound in attractive features, but make no mistake: the fine print shows there are headwinds that can cause considerable portfolio turbulence. Liquidity, inflation, political instability and restrictions on overseas investors are some of the biggest hurdles. Geopolitical, transparency and corporate governance are other issues to consider.

Mesburis concedes these markets are illiquid, but suggests there are different ways to access them. “For example, Africa is not a very liquid market in general so a good way to access Africa is through South African companies that invest in various parts of Africa.”

Mesburis adds South Africa is a liquid and developed capital market versus “something like the stock market in Ghana which is only open a couple days a week,” even in this day and age of electronic trading networks where high-speed, round-the-clock trading is something of a norm.

“I take those things into consideration when entering a position in some of these smaller markets because I don’t want to be caught on the wrong side of a liquidity trade,” he says.

Nannini concurs. “The liquidity in most frontier markets is still generally poor [and] significantly lower than in some of the larger emerging markets, which is why we view this asset class not as a substitute to a core emerging market portfolio, [but] more a complement to core allocation to some of the larger markets.”

Active management, says Asdhir, is the way to play these markets. “Buy and hold does not work,” he asserts. “It’s critical to understand the market cycles. Frontier markets have the potential for higher returns than the larger markets, but you cannot just sit there.”

Portfolio pundits go to considerable lengths to stress that exposure to frontier markets should be seen as part of the diversification benefit within a total portfolio. If investors look at the emerging markets as an integral part of global diversification in their portfolio, they can put a comfortable gap between rich returns and crippling losses.

Vikram Barhat