Not Such a Wild Frontier

by | Jun 30, 2014

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Frontier funds might boldly go where some others fears to tread, but that doesn’t mean they shouldn’t be part of a balanced portfolio.  City Editor Neil Martin reports

No, we won’t deny it. The very name ‘frontier markets’ has a frisson which is variously thrilling or terrifying, depending on your point of view. And, considering that the majority of candidate countries are, in City parlance, still short of even emerging market status, you can understand why frontiers are a step too far for most investors. 

And yet all the evidence is that frontier markets are not just gaining ground on their better-known neighbours, they’re actually growing faster. Last year, Morningstar reported that frontiers had put on 20% while the BRICs stagnated or fell. By May 2014, the MSCI Frontier Market Index was showing a massive 30% year-on-year growth. Although, as we’ll see, you do need to take the rough with the smooth.


Coping with the Risk

But surely, you protest, the rosy picture stops short when you look at the underlying macro fundamentals of places like Nigeria or Vietnam or Egypt? How is an investor to cope with the political instabilities, the liquidity shortages, or the heavy national dependences on single industries that tend to afflict these faraway locations?

Just try asking Michael Levy, the Lead Manager of Baring Frontier Markets Fund – one of the earliest frontier adventurers, which has been around so long that it was already an experienced player when the Berlin Wall came down in 1989. In time, of course, the primitive East European scene went on to achieve true Emerging Market status, but by that time Barings was away into Latin America and then Asia. Its $635 million Baring ASEAN Frontiers Fund and its strongly performing Baring MENA Fund are now taking clients into new areas of Asia, the Middle East and North Africa.

Danger? Levy won’t have a bit of it. Contrary to what you might believe, he suggests, frontier markets funds are not in fact an edge-of-the-seat ride – and indeed, they are in many ways more conservative and slower moving than emerging and developed markets funds. For these funds it’s the long game that matters – to see how history, culture and current affairs combine to produce a viable investment opportunity.


Gordon Fraser, one of the emerging market specialists at global investment manager BlackRock, agrees. “Although the underlying countries may appear volatile, if you’re just watching the BBC news, the actual aggregate of the index is not that volatile. Frontier markets volatility is running only at about 7-8%, which is less than emerging markets.”


What’s a Frontier Market Anyway?

So how do you define the frontier markets sector? Definitions vary, but most funds measure themselves against the aforementioned MSCI Frontier Markets Index, which classifies some 31 countries as ‘frontier.’ Of which 25 are formally included within the MSCI Frontier Markets Index. In terms of assets, the index has just over 142 constituents with a combined free float-adjusted market capitalisation of around $140 billion.



MSCI Frontier Market Constituents



Full Members




As with the UK football leagues, countries can be ‘promoted’ out of frontier and into emerging, and vice versa. Just last month, in what’s known as the Semi-Annual Index Review, Qatar and the United Arab Emirates (UAE) were lifted from frontier into emerging. Whereas Morocco has gone the other way, from Emerging into Frontier. And BlackRock’s Frontier Trust currently includes Saudi Arabia, which is not in the MSCI index.


George Birch-Reynardson, manager of the Somerset Capital Frontier Markets Fund which launched last December, insists that the distinction between the frontier and emerging is becoming increasingly blurred.

 “We do include some of the smaller emerging markets that perhaps don’t get the attention they deserve,” he says. “Like Peru and the Philippines, for example. They do share many of the characteristics you would say are classic frontier markets, in that they have very strong demographics and quite high growth.”

Which countries do our panel particularly favour? Nigeria, Bangladesh, Pakistan, Saudi Arabia and Sri Lanka were all frequently mentioned. Slightly lower down the list were the UAE, Sub-Saharan Africa and Dubai. Liquidity can be a problem though: many of these countries suffer from shortages of stock issues which periodically create cyclical demand surges and even bubbles.



What About Performance?

As for performance, frontier markets funds have had a wonderful run over the last 18 to 20 months, but this year has proved tougher. Which leaves Reynardson at Somerset feeling slightly rueful. “In general I’d say that during the last 18 to 24 months the valuation gap [for frontiers] was quite attractive, so they traded at quite a good discount to the emerging markets. But now, if anything, they are slightly more expensive.”

That’s a view which gets support from Fraser at the BlackRock Frontier Trust team. “It’s time for a bit more of a differentiated approach to frontiers,” he says. “When we launched the investment trust more than three years ago now, we were very bullish on frontier markets because we found them at a discount to emerging markets for far superior fundamentals.


“That discount has now closed. Frontier markets now actually trade at a small premium in terms of emerging markets. But we still believe in general that the fundamentals are far superior – lower debt levels, high dividend yield, better growth, less correlated markets and less institutionalized markets.”

“The world’s frontier markets will grow by an annualised 5.8% through to 20501. This compares to growth of 4.4% for emerging markets, while the developed world is set to grow by just 2.1% over the same timeframe.”

Frontier markets have low levels of correlation with both developed and emerging markets, as well as low intra-country correlations, and we believe that a degree of exposure to the asset class warrants serious consideration by investors prepared to take a long-term view.

Closed Or Open-Ended?

Ironically, the Somerset team is having to deal with its success. “We’re looking for relatively small investors,”says Reynardson, “but the interest we’re getting is often from larger investors. We’re actually capping our fund at around $300 million dollars, so some of the larger investors are saying well, we’ll take the whole lot, which is not ideal, because you want to have a diversified client mix.”

Typically, ‘proper’ frontier funds have tended to be closed-ended, because that gives the managers the freedom to ‘lock into’ a portfolio and stick with it through thick and thin. Unlike open-ended funds, which are constantly having to buy and sell assets in line with fluctuating fundholder demand, the closed-ended manager can commit to a multi-year position without fear.

Reynardson’s fund, for example, is an LLC based in the US, mainly because of its large US client base. But he adds: “I think an investment trust is actually an attractive vehicle for this sort of frontier markets fund because you’ve got the flexibility to access some of the less liquid stocks, which is often where the best opportunities are. We’re contemplating doing an investment trust further down the line, which would be run identically to the LLC.”

The Five Factor Approach

Michael Levy at Barings takes a different approach. His fund is an Irish Authorised UCITS launched in April 2013, which aims to achieve long-term capital growth through frontier market investment. The management team, he says, looks for companies that have very strong growth prospects; ones that haven’t been recognised by the market; and ones that trade at a reasonable valuation.

So far, so normal. But Barings’ stock picking process is unusual. As you’d expect, Levy says, the managers “build financial models and forecasts, and we do detailed valuation work.” But there’s more.

“The way we do our research is on a five factor model. We look at factors on what we call the GLCMV framework. G is for Growth, L is for liquidity, C is for Currency, M is for management and V is for valuation. One of these factors, or a combination of several, can be the spark for an investment idea.”

“It’s worth also stressing,” he continues, “that within frontier markets we pay a lot of attention to corporate governance. That’s the ‘M’ part of our research framework. We try to invest in companies in which management really are managing the business on behalf of minority shareholder interests. We try and identify companies that have got a sustainable competitive advantage period in the medium term, and companies that allocate capital effectively and efficiently.”

Corporate Governance

One aspect of frontier markets which you don’t immediately think about is the traditional company visit. Company management in Europe and the US, and in most emerging markets, are nowadays fully au fait with the ritual of the company visit, when a ‘dog and pony’ show has to be put on for investors, analysts, or the media.

But, as Reynardson points out, it can be a less polished affair in the frontier markets sector. Like most fund managers, they personally visit every company they invest in. He recalls that in Bangladesh, many of the company management “…genuinely don’t know what you’re doing there. Meetings are often trickier because they are so unused to them. And it can get frustrating.”


Political Stability Issues

But as an outsider looking in, you still can’t help but ask the nagging question about the stability of some of those countries. Maybe you can accept that volatility across the board is lower than in emerging markets; but seemingly every night you see one of the countries in the news for the wrong reasons.

Our specialists were pretty united on this one. To a man, they explained that it’s a long term play, and that worrying about particular news events is the wrong approach.

 “Let’s take Nigeria as an example,” says Levy. “Where Boko Haram are operating is often in the north and north east of the country; but most of the big companies are in the south, and many of them don’t have a presence in the north.”

Reynardson reiterates that it’s a long term play. “You aren’t ever going to avoid political upheavals,” he says, “and the way we look at it, we’re not going to be able to predict the political developments. But what we can do is to try to monitor the macro risk – and, where we see deterioration in a country’s balance sheet and inflation ticking up significantly, limit our exposure there.

Profiting from the Moment

“With a political crisis, you can have a very short term decline in the underlying stock market, you can often get a reasonable short recovery if and when there is a solution found. Whereas with a macro deterioration, you can have a long term decline in asset prices, and that is often manifested in a blow-out in the currency. So that’s our main worry.”

Blackrock’s Fraser adds that unrest in a frontier markets can actually work in an investor’s favour. “Ukraine this year has suffered tremendously on the back of the confrontation with Russia,” he says. “But from this political instability we’ve actually added to our exposure. We took advantage of the sell-off and the currency devaluation there to add exposure. So typically, we find that when others are fearful, it’s a good time to invest.”

What Of the Future?

“Frontier markets is an asset class that is increasingly being recognised as something that’s compelling and can’t be ignored,” says Baring’s Levy. “These markets offer an investor the opportunity for very strong growth – and growth often at a premium to both emerging and developed markets.

“These are very young economies which are just starting to develop, and as a result they are some of the most dynamic economies of the world. I ask you to turn the clock back 20 years to China, when this was still an unknown economy that was growing rapidly. Many of the frontier markets economies we’re investing in currently have many of the characteristics that made China and other emerging market economies a success story.”

 “The long term story is fantastic,” agrees Reynardson, “because of that higher return profile that you can get. I also think with a lot of these markets they are genuinely under covered and under-appreciated.”

Fraser at Blackrock is also bullish, but he adds some caveats. “You got to have a long term view and you have to be careful as well. There are lots of pitfalls, and you’ve got to be careful to lock in returns.

“As these countries develop and the capital markets develop, this will be a much larger asset class, and therefore there is a good opportunity for people to invest their money on a long term time horizon with an active manager. But agreed, there are short term challenges.”

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