Frontier Markets have formed a key component of our exposure within emerging markets since 2013.
Over this time our choice of fund has delivered a total return of 78 per cent. By comparison, the MSCI Emerging Markets index is up 23 per cent and the MSCI Frontier Emerging Markets index is up 29 per cent over the same period.
What are frontier markets?
As anyone that has been to Shanghai over the last 20 years will attest, the degree of change in 'emerging markets' has been phenomenal.
Consider how many new developments in these countries will make use of the latest technologies and it is easy to understand why some consider the quality of infrastructure to be higher than that we enjoy in so called ‘developed markets’.
This means that for investors, the historical benefits of investing in emerging markets are less pronounced today, as the fundamental gap between the two has partially closed.
Emerging markets are still a very attractive investment destination, but with few exceptions the periods of 'super normal' growth are unlikely to be repeated – the buildings, roads and railways have already been built.
Frontier markets are countries that are earlier in their development cycle – where today's emerging markets were around 20 years ago. Financial market index providers MSCI and FTSE class the countries in the table below as frontier.
Frontier market economies
Source: EQ Investors
Why invest in frontier markets?
We’ll be the first to admit there is no direct link between economics and market performance. As Brexit and Trump have both proved over the past year, external factors can have a larger effect on markets, while underlying economic trends continue much the same.
Nonetheless it is hard to deny the fastest growing countries on the planet are in frontier market economies. With that growth comes investment opportunity.
Several emerging and frontier markets are heavily tied to commodity prices, as their largest growth drivers are extractive industries. In others consumer demand is a significant, if not the major driver. These consumers may not be working in offices, or on their smartphones, or drinking Starbucks – they are more likely to be working in factories or running micro enterprises with significantly less disposable income. But their incomes are nevertheless rising and with that comes greater spending power on a whole host of staples: for example food, beverages and household items. There are lots of local companies serving this consumer demand, many of which are publicly listed.
Performance of MSCI Emerging Markets vs MSCI Frontier Markets over 3yrs
Source: FE Analytics
The benefits
One of the key advantages of frontier markets is that they are less interwoven into the global trade system and so companies within these stock markets will trade based more on local than global factors.
Whether or not a Pakistani bank is lending more or less to small and medium enterprise will have no impact on whether a Vietnamese dairy company is successful. Compare this with the recent outperformance of US banks (and underperformance of consumer goods) – driven primarily by the anticipation of rising interest rates.
Funds that invest across multiple frontier markets can actually demonstrate relatively low price volatility – despite being invested in an inherently more ‘risky’ asset class (though perhaps no more risky than the emerging markets of yesteryear).
In addition, frontier markets are generally under-researched by comparison to their emerging market peers. For every analyst researching a Vietnamese company there are four looking at a Nigerian equivalent and twenty researching a company in China. This means there is greater potential for mispricing of companies in frontier markets and consequently greater profit potential for savvy investors.
In comparison to developed markets, valuations in frontier markets trade at around a 25 per cent discount. These are the world’s fastest-growing economies, with favourable debt and demographic tailwinds.
Of course, there are also considerable risks in each individual frontier economy, including the potential for political upheaval or capital controls. For this reason we would never consider a passive approach to the region, or one which is not diversified across a number of countries.
We have historically invested through HSBC Frontier Markets. However, as the competitive landscape has shifted over the last few years we are now switching over to Charlemagne Capital’s Magna New Frontiers Fund. We are also weighing up the benefits of adding a second frontier fund to the mix, and are in the process of shortlisting managers whose investment could offer further differentiated risk characteristics.
How do we invest?
We have historically invested through HSBC Frontier Markets. However, as the competitive landscape has shifted over the last few years we are now switching over to Charlemagne Capital’s Magna New Frontiers Fund. We are also weighing up the benefits of adding a second frontier fund to the mix, and are in the process of shortlisting managers whose investment could offer further differentiated risk characteristics.
Kasim Zafar is a portfolio manager at EQ Investors. The views expressed above are his own and should not be taken as investment advice.