Are frontier markets worth the risk?

This collection of the fastest-growing global economies, which includes Pakistan, Vietnam and Nigeria are better known for geopolitical crises and commodity shocks than their popularity with investors. However, waning returns from the emerging markets sector have pushed investors towards less developed markets which offer potentially better long-term returns and the lure of undervalued stocks.

The frontier markets outperformed their emerging market counterparts in 2013 and 2014. The rise in the MSCI Frontier index last year can be attributed in part to the soaring prices for Qatar and the United Arab Emirates in anticipation of their promotion to the MSCI Emerging Markets index.

Annual performance (%) of frontier markets vs emerging markets

However, according to Michael Levy, investment manager at Baring Frontier Markets fund, in January the MSCI Frontier Markets Index was offering almost twice the return on equity than the MSCI Emerging Markets Index for a lower projected price/earnings (PE) ratio - 17.8 per cent return compared with 8.45 per cent with a PE multiplier of 9.28 times compared with 11.48 times.

Even volatility measures look surprisingly low on a long-term basis. According to annualised standard deviation figures (the key measure of volatility), the MSCI index has been less volatile than the FTSE All-Share, at 10.11 compared with 11.96 for the All-Share over three years, and is comparable to the MSCI Emerging Markets Index figure of 10.7.

That is in part due to frontier markets' insulation from the global financial system. Peter Sleep, senior portfolio manager at Seven Investment Management, says: "These markets tend to be more independent markets and slightly more value orientated markets. They tend to be less correlated and are a good diversifier for a more aggressive portfolio as a result."

According to TrustNet data, over the past three years the MSCI Frontier Markets index had a correlation of just 0.56 to the MSCI World index compared with an MSCI Emerging Markets correlation of 0.7 Perfect positive correlation (a correlation co-efficient of +1) implies that as one security moves, either up or down, the other security will move in lockstep, in the same direction.

Not all good news

But small stock markets, a lack of investable stock and currency risk also means these markets can be illiquid and hard to penetrate. Even the largest frontier markets are much smaller and more concentrated than more developed markets. Darius McDermott, managing director of Chelsea Financial Services says: "The real risks are political, corporate governance and liquidity, or how many shares trade per day. For example Nigeria has around 200 companies listed but only 25 are large enough to attract a fund manager."

Laith Khalaf, senior analyst at Hargreaves Lansdown, says: "To invest in frontier markets you need a big portfolio with exposure to emerging markets within it. Maybe with a portfolio of around £200,000 to £300,000 you could dabble a few thousand pounds in something racy like frontier markets but it would have to be a very long-term investment. There will be a lot of ups and downs."

Nigeria

Nigeria was once seen as the gem of the frontier markets sector. A thriving banking, telecoms and consumer staples sectors combined with a major brewing industry meant the economy has flourished and last year it became Africa’s largest economy with a GDP of £307bn.

But with 95 per cent of Nigerian exports related to oil production the country was hit hard by last year's dramatic oil price crash and recent political furore over delayed elections has sent the currency sliding to a record low of just over 196 to the dollar.

However, long-term positivity remains in some quarters. Thomas Becket, chief investment officer at Psigma Investment Management, says: "I wouldn't be too bearish about Nigeria on a long-term perspective, it's one of the more liquid frontier markets". While Bernard Moody, co manager of Advance Frontier Markets Fund (AFMF), says: "The demographics give enough comfort to maintain exposure to that market and in the banking sector the stocks are as cheap as anywhere in the world."

Funds like AFMF and Blackrock Frontiers Investment Trust (BRFI) have been reducing their exposure to the region but BRFI co-manager Emily Fletcher is positive over the long run.

"Longer-term stocks in Nigeria are trading on very cheap valuations," she says. "Zenith Bank stocks are now trading on less than five times PE, so we are seeing very sensible valuations in local currency terms and very underpenetrated in almost every sector."

Vietnam and Southeast Asia

Vietnam still looks appealing. Economic growth accelerated in 2014 after an increase in bank lending and an increase in foreign investment. A combination of new fiscal policies and oil price drops have also led to falling inflation rates and restabilising of the currency.

Mr Becket says: "In markets like Southeast Asia we're quite cautious about the valuations but markets such as Vietnam have a lot of opportunities."

The market turned heads in 2013 when its chief stock exchange rose 20 per cent, the best performance of any Southeast Asian exchange and its MSCI index has returned higher results than the MSCI Frontier Markets for the past three years. That was a turnaround on a drop of 38.14 in 2011.

Countries such as Banlagesh, Sri Lanka and Pakistan are all attractive as beneficiaries of lower oil prices. Bangladesh rose 60 per cent last year according to Ms Fletcher, who says her fund has been significantly adding to positions in South Asia including Bangladesh, Pakistan and Sri Lanka.

Arne Noack, head of exchange traded products (ETPs) at Deutsche Bank says: "There was a period of time in summer last year and mid end of October where the Bangladesh market rallied fairly significantly so if you had that in your portfolio as a diversifier you would have done very well. At the moment Pakistan seems to be rallying and has had quite a good run. We see some investors very tactically investing in these countries."

Ms Fletcher adds: "The extent of international involvement in these areas is very low, the percentage of trading is very low. Typically in Pakistan it's below 10 per cent and Bangladesh it’s below 5 per cent which makes those markets very interesting. In a typical day in Nigeria you’re talking more like 60 per cent."

Best frontier markets funds

INVESTMENT TRUSTS

IC Top 100 fund BlackRock Frontiers Investment Trust (BRFI) and Advance Frontier Markets Fund (AFMF) are two of the main closed-ended options.

Blackrock’s frontier trust is managed by Sam Vecht and Emily Fletcher and until last year had delivered stellar performance. But underweight positions in the UAE and Qatar hit performance against the benchmark when both markets soared ahead of their promotion to the emerging markets index last year.

Ms Fletcher says: "We are very true to our mandate and our style and as we saw the UAE and Qatar becoming expensive we took down our positions. We took them down too early relative to the index, so we therefore had a bad year but we were completely consistent with what investors expect us to do."

Mr Vecht and Ms Fletcher focus on bottom-up stock selection and have identified key value stocks in South Asia such as Sri Lankan lubricant company Chevron Lubricants, which rose 17 per cent in December as a result of the oil price fall. After spending much of the previous two years trading at a premium the fund is now at a discount to NAV of 4.28 per cent and has an ongoing charge of just 1.45 per cent.

Advance Frontier Markets Fund takes a more top down approach to asset selection and has failed to match BlackRock’s performance over a three-year basis, returning 38.02 per cent. Over the short term the fund was also affected by underweight exposure to UAE and Qatar but returned 2.51 per cent in 2014.

Because it invests in other funds, alongside direct holdings in companies, Advance Frontiers Markets is more diversified than the Blackrock trust, with over 500 holdings. It also has a larger exposure to Nigeria, at 10.8 per cent. That is balanced with a 6 per cent position in Pakistan and 12.6 per cent in Vietnam.

At a discount of 7.10 per cent to NAV and total expense ratio of 1.58 per cent it is the cheaper option but may not deliver such high returns as its peer.

Open-ended funds

Schroder ISF Frontier Markets Equity fund (LU0971766711) has delivered higher cumulative returns than both BRFI and AFMF at 69.14 per cent over three years.

However, with just 59 holdings it is a riskier vehicle than AFMR and overweight financials versus its sector at 56.8 per cent. It is an offshore fund but available on platforms with an ongoing charge of 1.58 per cent.

If you want to back Africa and emerging European economies, reputed manager Nick Price's Fidelity Emerging Europe Middle East and Africa fund (LU0303816705) does offer a more narrow exposure to certain frontier markets. Over five years it has delivered returns of 30.61 per cent.

The fund is 65 per cent exposed to Africa, with financial services making up the largest proportion of its stock at 33 per cent and the fund has avoided Eastern Europe in recent months on a currency basis.

However, the risk factor appears high, with a standard deviation figure (the key measure of volatility) of 15.32 over the past three years, and a Sharpe ratio (quantifying returns given for risk taken) of just 0.15 according to TrustNet data, implying that compensation for the risk taken could be undesirable.

Exchange traded funds

Db x-trackers S&P Select Frontier UCITS ETF (XSFR) was launched in 2007 and tracks the newly-devised S&P Select Frontier index, which comprises the largest and most liquid frontier market stocks. It is less cheap than the average ETF, with a 0.95 per cent annual charge.

There are important differences between this and its peer index not least in country allocation. Argentina makes up 30 per cent of the S&P index, which could ring alarm bells for those not keen on such exposure to a single region.

The ETF is also more complex than others of its type. It is a synthetically replicating fund which uses swaps in order to get around the challenges of buying stocks in frontier markets such as dealing in local currencies.

db x-trackers FTSE Vietnam UCITS ETF (XFVT) is a $374m fund which tracks the FTSE Vietnam index. As a small bet this could add diversification but be wary of any fund with such focused exposure. Also be aware that any ongoing ETF charges do not include swap fee amounts.

Annual total return performance (%) of recommended frontier markets funds

Source: TrustNet 11.02.2015

Annual total return (%) performance of recommended frontier markets ETFs

Source: DeutscheBank. Data runs 1 January to 1 January