The difficulty in any discussion on frontier markets is in first defining what constitutes a Frontier Market (FM) and what characteristics distinguish it from an Emerging Market (EM). Various investment houses offer different perspectives on the qualifying criteria, ranging from empirical data, such as GDP per capita, levels of foreign investment or daily market trading volumes, through to whether the country has a Starbucks (on which basis Guernsey would be classified as frontier!!!). Though there is no formal definition, a number of benchmark indices have been produced and provide general classification parameters and a vehicle for comparative and investment purposes.
The perception of investing in FMs is that it should only be for highly aggressive or professional investors. However, notwithstanding that, in isolation, these markets come with embedded risks, any investor with even a basic understanding of Modern Portfolio Theory will know that the inclusion of a lowly-correlated asset into a portfolio provides potential diversification opportunities to lower the overall volatility of that portfolio. This point is important, as correlations between EM and Developed Markets (DM) have increased in recent years as EMs have matured and their economic cycles have become more synchronised, whereas those with FMs remain subdued.
In addition to the prospective diversification benefits, the returns achievable from said markets can be exceptional – consider 2015’s top global performer, Venezuela’s Caracas Stock Exchange, with a return of 280% in US Dollar terms. Since investment principle 101 states that there is a trade-off between potential returns and risk, FMs clearly come with substantial risk attached. However, there are also a number of tailwinds expected to drive FM economies and stock market performance going forward, including favourable demographics and urbanization. The resulting infrastructure investment and rising consumer spending through increased wages and wealth creation are precisely the factors that led to EM outperformance of DM 20 or so years previously. Moreover, minimal (or even zero) analyst coverage allows for stock mispricing discoveries.
The negative attributes of EM 20 years ago are also evident when considering FMs today: political instability, currency instability and capital controls, restrictions on foreign ownership, concerns over dealing transparency, substandard corporate governance, low levels of regulation, limited illiquidity and immature markets. But these same concerns can also be considered an opportunity, since, as markets mature and reforms are implemented, these concerns will abate, rewarding the long term investor with stock price re-ratings.
As is currently a hot topic in wider market circles – the ‘passive vs. active’ debate – the ideal vehicle of which to gain exposure to FMs is paramount, as can be seen from the divergence of returns amongst FM constituents over the last calendar year and beyond. In any asset allocation decision, it is prudent to consider the rationale for seeking exposure in the first place. With capitalisation weighted ETFs tending to be dominated by large banks, utilities and poorly run State Owned Enterprises, with only small weightings to the consumer sector, we would argue for active bottom-up managers over passive management.
In terms of portfolio activity, within our International Equity Fund, we have recently initiated a holding in a specialist Vietnam manager where the pro-business, pro-capital economy is beginning to thrive. Foreign direct investment is rapidly increasing, with known brands throughout the world setting up manufacturing companies in the region, supported by a reform-orientated government that supports the private sector. We also have FM exposure, to Sri Lanka, Vietnam, Pakistan and Bangladesh, through our preferred specialist Asian equity funds, while in fixed income one of our preferred bond funds has significant exposure to markets in the Middle East.
In our regular Monday morning investment committee meetings, we have also spoken of the prospects of an African allocation for international portfolios. Though very commodity-dependant, a number of countries possess very favourable demographics, which, when coupled with the rise in infrastructure spending from China’s continued involvement in the region should lead to a healthier consumer and an uplift in the economy.
While we are by no means advocating the rotation of a portfolio’s entire EM allocation into FMs, we are highlighting the emergence of FMs as an asset class in their own right and that the addition of a small allocation to this potentially lucrative area can have significant advantages to a well-diversified portfolio.
Is it time to look to the Frontier?
