Fresh out of business school in 1995, I joined Montgomery Asset Management, a firm that was among the earliest to invest in emerging markets. Emerging markets were considered a high-risk segment of the investment universe, avoided by many investors based on concerns about immature economies, illiquid stock exchanges and uneven respect for property rights.
My Montgomery colleagues saw potential despite the risks, believing that emerging markets would benefit from economic growth and political reforms. Emerging markets were thought to provide return enhancement as well as portfolio diversification, providing returns that weren’t highly correlated with that of developed markets.
Much has changed in recent years. Emerging markets is now a mainstream asset class, representing a meaningful portion of global stock market capitalization and commonly included in investor portfolios. South Korea has “graduated” from an emerging to developed market in the eyes of many investors, with China and Taiwan not far behind. Emerging market economies are more integrated with that of developed economies, leading to some erosion of the diversification benefits once provided by emerging markets stocks.
Enter the Frontier?
Frontier markets have much in common with the emerging markets of 1995. In their article, “The Case for Frontier Equity Markets,” Lawrence Speidell and Axel Krohne wrote that “ The entire world is moving, albeit with irregular progress, towards understanding and implementing the basic conditions for economic growth based on rule-of-law and incentives. As countries move along this path, the greatest rewards will come from places that have the greatest improvements to make.” Speidell and other investors in frontier markets cite favorable demographics, improving political stability and increasingly pro-growth government policies in support of their investment thesis.
Africa offers an example of Speidell and Krohne’s thinking, featuring a land mass that is bigger than the U.S., China and Europe combined, and GDP of only 6% of the world’s GDP. The potential for growth is significant.
Some of the world’s fastest-growing countries are included in the frontier markets universe, and projected growth exceeds that of developed and emerging markets.
Labor force growth, anemic in most of the developed world, is expected to be robust in the frontier world (see Chart 1 below). Dependency ratios – the number of non-working age people to working age people — are projected to decline steeply in frontier markets while the opposite is expected to occur in developed markets.
Frontier markets have been beneficiaries as formerly low-cost emerging market countries evolve economically and cede some manufacturing jobs to lower-cost countries. For example, rising wages in China is a catalyst for some manufacturing activity to move from China to countries such as Bangladesh and Vietnam.
The frontier markets investment universe includes resource-rich countries such as Nigeria and Kazakhstan as well as less commodity-dependent countries such as Bangladesh, Pakistan and Sri Lanka.
Argentina, relegated from the emerging markets investment universe to the frontier markets universe after decades of economic mismanagement and leftist political control, has become an investor favorite under the market-friendly leadership of Mauricio Macri.
Pakistan, helped by strong GDP growth, a robust banking sector, and improving security and infrastructure, is another country gaining in popularity among frontier markets investors. Estonia was one of the best performing frontier markets in 2015, helped by the success of a cruise and transport ferry operator that benefited from low oil prices.
Saudi Arabia is an interesting case, as it isn’t included in the MSCI indexes for emerging or frontier markets, but has its own stand-alone index. Some investors think of Saudi Arabia as a frontier market, while others speculate that it will skip directly into the emerging markets indexes after the public offering for Saudi Aramco.
In an increasingly interconnected world, frontier markets remain more local in character, influenced more by local economic and political factors than by global factors. Consequently, frontier markets are less correlated to both emerging and developed markets, potentially providing the diversification benefit that was attractive to the first generation of emerging markets investors.
Frontier markets also are relatively less correlated with one another, another benefit in a world in which diversification is becoming much harder to find.
So How to Invest in Frontier Markets?
Investing in frontier markets isn’t for the faint of heart! The potential rewards are significant, but the risks shouldn’t be ignored. Frontier markets were in the news recently with the downgrade of Saudi Arabia’s debt by Fitch Ratings and the potential removal of Nigeria from the MSCI frontier markets index. Both countries face challenges caused by falling oil prices. Saudi Arabia’s budget is under pressure, and Nigeria has imposed foreign exchange controls in response to the hit to their economy caused by falling oil prices.
Challenges to investing in frontier markets include lack of timely and accurate data, limitations to market access, liquidity, corruption and economic and political inefficiency.
We recommend a diversified approach to investing in frontier markets, to reduce the risk associated with adverse developments in a single country or economic sector. We’ve been wary of the indexes used in the frontier market asset class, finding them to be overly concentrated in country and sector terms.
The MSCI Frontier 100 Index, the index used for one of the most widely used frontier markets ETFs, has 50% concentration in the financial services sector. The index also has extreme concentration at the country level, with more than 50% represented by just three countries: Kuwait, Argentina and Nigeria.
In addition, the larger/higher growth countries have ‘graduated’ to Emerging Market status and created index rebalancing risk. For example in 2014, Qatar and United Arab Emirates accounted for over 30% of the Frontier index prior to leaving the index.
Consequently, we favor an actively-managed approach that attempts to distinguish between winners and losers at the country, sector and company level. Given the potential performance divergences between best and worst performers, we think that well-managed active strategies represent a superior solution than index-oriented alternatives.
Even though frontier markets have many risks, it is interesting to note the market trades at a discount to emerging and developed markets. Currently, the frontier markets trade at a P/E of 10.0 vs. 12.7 for emerging markets, 15.7 for other developed markets and 19.4 times for the U.S. market. You could say some of the risks have been already priced into the current price.
Although we are mindful of the risks of frontier markets, with patience and proper due diligence, we think that frontier markets can be a rewarding addition to investor portfolios.