Frontier markets may have some of the look and feel of emerging markets, but they are not simply a higher risk, faster growth version. They stand as a separate asset class, with distinctive characteristics and can bring something very different to a portfolio. 
Frontier markets are countries at an earlier stage of economic development. These might include countries such as Bangladesh or Kenya, where GDP per capita is low, but they are growing fast, or some countries in the Middle East, where there is considerable wealth, but capital markets are less developed, and access can be more limited. Capital markets in these countries tend to be dominated by domestic investors and they are often tough to research for global investors. As such, they are overlooked by many international investors without the resources to get into the weeds.
However, we believe they merit greater attention. The major emerging markets can be vulnerable to the ebb and flow of international capital. Money will flow in when optimistic asset allocators are looking for higher growth and flow out when global growth slows. Frontier markets, in contrast, are influenced more by local money flows than what’s happening on Wall Street. Kenyan banks care what’s happening to the Kenyan economy rather than the global economy.
This means a frontier market allocation will have much less correlation to both emerging and developed markets than they will to each other. Their economies often have few connections to the global financial system. In the BlackRock Frontiers Investment Trust, we have over 20 different geographies represented and none of these form more than 15 per cent of the overall portfolio.
A portfolio of frontier market companies can potentially lower the overall volatility of a portfolio. This is counter-intuitive because smaller and less liquid companies generally see greater volatility. While this is true for frontier markets at an individual stock and country level, each individual market is so different from the others, blended together there is lower volatility.
Research from independent investment trust analysts, Kepler, found that since launch in December 2010, the volatility of the trust’s underlying holdings has been lower than any other emerging markets trust, lower than the FTSE All Share and the MSCI World.
A third element that investors might not expect from companies operating in countries at this early stage of development is an income stream. Income is not an explicit objective of the fund and yet the underlying income for the fund is currently 3.7 per cent. It has also shown reasonable growth over time. This is a happy accident of the underlying companies in the trust, which are often extremely cash generative. Many of the companies don’t have the opportunities to invest across borders and expand into new markets. They are focused on local growth. As such, they’re piling up cash from their fast-growing local operations, which has nowhere to go except to be returned to shareholders.
These are the advantages of investing in frontier markets. Nevertheless, they come with their challenges for investors. These markets often have oddities: it may be difficult for foreign investors to buy on local exchanges, there is often less information available, with limited broker research. It only suits those who are willing to roll their sleeves up.
On the BlackRock trust, we use a mixture of top-down macro-economic analysis and bottom-up fundamental stock research to build their portfolio. First, we have devised our own process to assess these countries’ economies, creating a ‘macro dashboard’, which looks at the economic cycle for each country in their universe, guiding us to likely areas of interest. We prefer to be invested in countries that are early-cycle, seeing stabilising and rising currencies and falling bond yields.
For the companies themselves, we like stability - predictable earnings and cashflows, organic growth and a compelling valuation. Frontier markets tend to be less well-researched than more developed markets, which means mispricing is more evident.
At the moment, it is leading us to countries such as Egypt. It is a poster child for structural reform with the fiscal deficit closed and the current account in surplus, thanks to a boom in tourism and energy exports. The trust owns a medical diagnostics company, currently eyeing the huge Nigerian market, and a construction company. Vietnam is another area of interest, as a potential beneficiary of the US/China trade war. The country has already seen lots of outsourcing from China. Even unloved Argentina features, where there is huge potential after its harsh devaluation.
The trust has recently expanded its universe to include all but the eight largest countries in the MSCI Emerging Markets index. This retains the diversification elements, the average emerging markets fund portfolio in the Investment Association sector is 75 per cent invested in the largest eight countries in the MSCI Emerging Markets index but creates greater stability of the investable universe. The MSCI Frontiers Market can change composition relatively regularly and we don’t want to be forced to sell good holdings just because a country has dropped out of the index.
At a time when markets are becoming more volatile, the temptation may be to shy away from smaller, earlier stage investments, but we believe this would miss the point. Frontier markets are not a high-octane version of emerging markets but can be a stabilising force in a portfolio.
Emily Fletcher is co-manager of the BlackRock Frontiers Investment Trust. The views expressed above are her own and should not be taken as investment advice.