Investors who have the wrong idea about risk in frontier markets could miss out on significant gains from a sector that is finally getting its act together, according to Ashmore’s Andrew Brudenell.
Data from FE Analytics shows that the MSCI Frontier Markets index has a volatility score of 14.97 per cent since its launch just under 10 years ago, which is lower than the 21.22 per cent score of the MSCI Emerging Markets index and 16.88 per cent from the MSCI World.
However, Brudenell, head of frontier markets at asset manager Ashmore, said that amateur and professional investors alike continue to confuse political and individual country risk with the volatility of a diversified frontier markets fund – which he described as one of his “biggest bugbears”.
“I read it all the time in consultancy reports and media reports from wealth management advisers and all these sorts of people,” he began.
“They say: ‘Yes, yes, yes, frontier markets are very exciting, there are lots of changes going on, isn’t it great, but everyone should be aware it’s incredibly risky. Very, very risky, you never really know what is going to happen and it is all very scary’.
“To my mind, what they mean is, ‘don’t go on holiday in Pakistan’. I don’t think they understand – the idea of these countries being a little bit risky is one thing, but the idea that there is less transparency and therefore you never know what these businesses are going to do, I think it kind of misunderstands what is happening.”
Brudenell said the first thing to note when looking at frontier markets is that it is all about relative change. While he admitted these businesses and economies are not going to look like Europe anytime soon, he pointed out it is about where they are coming from, what path they are on and where they are trying to get to.
The second is that while most people in the developed world may not have heard of many businesses in frontier markets, they are well known in their own countries and are often leaders or potential leaders in their chosen field.
“Domestically they are already in the limelight and there is quite a lot of oversight and governance – it’s not nearly as bad as people make out,” he continued.
“And if you do the work and actually meet these guys and spend time grilling them and asking them questions, you can get quite a lot of information.
“So I think that perception of risk isn’t quite right.”
Even if there is volatility in individual markets and stocks, Brudenell said, this is likely to be contained and the geographical spread of countries within his portfolio means this will have a minimal impact on the overall fund. He even said the disconnected nature of frontier markets – more than 50 per cent of daily stock market flows are driven by local retail investors – may act as a stabilising force when the rest of the portfolio is experiencing volatility.
“Do you really believe the guys in the Nigerian stock market wake up in the morning and go ‘right, I wonder what happened in Vietnam overnight? I better have a check’. These guys are not doing that,” he explained.
“They are very much blinkered, focused on their own country, focused on their own hopes and dreams and rumours and ‘I know a guy who knows a guy and he said this business is going to do this and that’.
“There’s a lot of that type of thing going on, which creates inefficiencies and volatility, but uncorrelated volatility.”
For example, Brudenell pointed out the correlation between Argentina and Kuwait, the two largest countries in the MSCI Frontier Markets index, currently stands at close to 0.1 (where 1 equals a perfect correlation and 0 equals no correlation).
“Even Kuwait and Saudi,” he continued, “which a lot of people may think of as being the same place – they are both oil exporters, they are both right next to each other, they are both dollar pegged – their correlation is 0.5.
“Meanwhile, emerging markets are correlated with developed markets generally at something like 0.85. As maths teachers taught us, if you have a diversified portfolio of volatile assets, actually that volatility comes down a lot.”
Despite Brudenell’s claims, the maximum drawdown – the amount investors would have lost if they bought and sold at the worst possible moments – of the MSCI Frontier Markets index since launch in February 2008 stands at a hefty 53.78 per cent. While only marginally higher than the 52.21 per cent of the MSCI Emerging Markets index, this is significantly above the 37.89 per cent of the MSCI World.
However, these losses were incurred during the financial crisis. The maximum drawdown for the MSCI Frontier Markets index from the start of 2009 stands at 24.23 per cent, well below the 28.82 per cent figure from the MSCI Emerging Markets index and only slightly ahead of the 23.13 per cent from the MSCI AC World index. Brudenell said this is significant because far from trying to forget the crash of 2008, policymakers in frontier markets have learnt from their mistakes.
“An unprecedented number of countries are now putting their hands up and saying: ‘We’re going to make reforms, we’re going to make changes. We need to get our act together, we need to move forward’.
“Why? I guess we’ll never know why, but my guess is that the global financial crisis was pretty horrific and it was a bit of a wake-up call for everybody and their egos. It came after a pretty long period of the world being great and everyone feeling pretty much anything they did was a great idea, with everything going up – it came as a bit of a reality check.
“But what is interesting is the government ministers I have spoken with tell me that actually some of the core frontier guys were in places like Nigeria and Vietnam in 2009, in these places that had real problems, going ‘right guys, don’t worry about that, that happened, it happened to everybody, but what we really want to know is, what are you going to do about it? How are you going to ensure this doesn’t happen next time?’
“The local retail investors weren’t anywhere to be seen, they disappeared, they were absolutely petrified.
“I think basically, business leaders and regulators and governments began to realise that ‘actually foreign investors can be pretty helpful here and actually if we can begin to get some of these things right, investors will come back’.”
Brudenell said that this process of reform is accelerating as more frontier nations take notice of how quickly some of the larger emerging markets such as China, which are a few steps further down this path, have recovered from the crisis.
The manager also noted that because most businesses in frontier markets are domestically focused, they are not dependent on global trade or what is happening with quantitative easing, for example, as some of the larger emerging markets are.
“It is more about if you want to make this happen, you can, you just really need to get on that path and keep communicating with the world and keep building confidence, building relationships with local leaders and so on,” he added.
“Loads of developments can occur that really then build confidence, build growth, create sustainable growth and quite high returns, because these people are coming from very lowly penetrated industries.
“So the fate is in their own hands,” he finished.