19th December 2012
The fan base for these markets is certainly expanding. In a recent broker's note, Oriel Securities said that frontier equity markets may prove to be a more effective long-term store of value than government bonds or cash. Admittedly, the likely returns from government bonds or cash are limited.
Frontier markets can be found all over the world, but are concentrated in Africa and the Middle East with countries such as Kenya, Nigeria and Saudi Arabia among their number. They may be deemed 'frontier' because of poorly developed capital markets, barriers to foreign ownership, or simply because of low per capita GDP. People have been excited about them before, notably through launches such as New Star's Heart of Africa fund, which hit liquidity problems and lost investors the lion's share of their money.
Is it different this time? More recently, there have been a number of new launches in frontier markets, usually, but not exclusively, in a closed-ended structure, such as BlackRock Frontiers Investment trust. The granddaddy of the sector is Advance Frontier markets, but Templeton's emerging market guru Dr. Mark Mobius also runs a Frontier markets fund.
Many of these funds have offered exciting returns. Although both have been volatile, the Templeton Frontier Markets fund is up 17.2 per cent over the past 12 months and BlackRock Frontiers Investment trust is up 16.4 per cent (source: Trustnet). But the path has not been smooth, even for experienced managers such as Dr. Mobius and Sam Vecht, the manager of the BlackRock fund. Both saw significant losses in the risk averse markets of 2011. This highlights one notable peril of frontier markets – it doesn't matter how strong the economic growth is in a particular country, if investors become more risk averse, they will sell out.
Nevertheless, frontier markets have some vocal supporters. Oriel Securities as this view on website Trustnet shows. Advocating the asset class Dr. Mobius says: "Frontier markets are typically smaller and less developed than emerging markets but are growing at a fast pace and could become tomorrow’s emerging markets. These newer emerging markets are found all over the world – in Latin America, Africa, Central and Eastern Europe and Asia. The list is long and includes such countries as Nigeria, Kenya, Saudi Arabia, Kazakhstan, Bangladesh, Vietnam, United Arab Emirates, Qatar, Egypt, Ukraine, Romania, and many more countries."
He argues that they offer the opportunity to invest in a “younger generation of emerging markets".
Certainly, the economic growth rates for these countries are exciting. This Investor's Chronicle article points out that Africa is the only region to have its outlook revised higher for 2013, on the back of thriving oil and metal industries as well as its agricultural potential.
In the latest global economic update from the IMF, much of Africa and the Middle East is showing growth levels largely unseen in the rest of the world. Sub-Saharan Africa, for example, has been consistently growing at a rate of 5 per cent or higher. The IMF highlights Kenya and Tanzania as typical examples of the strength of the region. It says: "Macroeconomic stability and market-friendly policies helped provide a durable growth impetus. As in much of Africa, growth in Kenya and Tanzania has been driven by strong domestic markets, led by a growing middle class. For both countries, an improved investment outlook contributed to a sustained expansion in private sector construction spending. At the same time, the adoption of new technologies has contributed to rapid growth in communications and finance. This engine of growth helped shield both economies from the global downturn, with spending on construction, communications, and finance continuing to grow."
In countries such as China, stock market performance has not reflected strong economic growth, but stock market performance tends to bear a stronger correlation to economic performance in frontier markets. This is largely because in under-developed capital markets, the companies that are the first to list are the large ex-state owned enterprises, such as oil companies and banks. These tend to reflect the growth in the economy. It is therefore safer to assume that some of this strong economic performance will translate into rising equity prices.
However, these are not widows and orphans investments i.e. prospective investors should use money they can afford to lose. Liquidity remains a key problem with many of these markets exhibiting thin trading volumes. Often, this is compounded by currency problems. If there is a crisis, everyone wants to get out of the economy and the currency at the same time. The exit door can then become extremely small and investors can lose a lot of money very quickly. Having a long term horizon and a skilled manager can help, but does not completely alleviate the problem.
Investors should, in theory, roam the globe for the best growth opportunities. Certainly, frontier markets present some excellent growth opportunities which should ultimately translate into stock market performance. However, the risks are high and investors should only enter these markets with that in mind.