If you'd suggested to private investors 20 years ago that they should put a substantial portion of their portfolio in the BRIC countries - the emerging markets of Brazil, Russia, China and India - they'd have probably thought you were stark-raving mad. Back then, emerging markets were not only insanely risky but also hugely inaccessible for private investors. Not any more, though - now hundreds of emerging markets companies are directly listed on either the US or UK main stock markets, and there are hundreds of funds that also invest in these markets. What was once forbidden in some countries (foreign equity ownership via freely traded shares) is now rare. The BRIC mega-caps such as Gazprom from Russia or Petrobras from Brazil are talked about in the same conversations as first-world mega-caps.
Many emerging markets have quite literally 'emerged' and are fast moving into the developed league - leaving behind them dozens of newer markets in countries as varied as United Arab Emirates (UAE) and Mongolia. This 'second division' of smaller, fast-growing, more risky countries forms a new frontier in investing - they are quite literally the new 'emerging markets', so new in fact that they're actually collectively called the 'frontier markets.' The dozens of countries and the thousands of locally-listed companies that make up this new world of globalised investing are the next great asset class. Even institutional funds have only recently caught on to this new world, scrambling into a small number of highly specialised funds - private investors have, up to now, been almost entirely absent from this space.
But intensifying financial globalisation, combined with new fund launches that make accessing the sector much easier, is about to force private investors to sit up and take notice of frontier investing. You can now buy into experienced investment trusts (from Progressive Fund Management) and index tracker funds (from Deutsche DBX) that follow the bigger companies in the frontier space and a small but growing number of listed UK and US companies offer direct equity exposure to some of the big economies in the frontier world.
What are 'frontier markets'?
Frontier markets comprise roughly one billion people, and about $2.4 trillion of global capital. Defined loosely by international bodies such as the World Bank, frontier markets are high-risk, low-income countries. Typically, they are:
• Difficult to access for outside investors,
• Fairly risky on the political (and economic) front,
• and they have the potential for huge returns and huge declines.
According to analysts at S&P - which has its own Frontier indices - frontier market economies have been growing at a "brisk pace since 2000". The graph below shows the average real gross domestic product (GDP) growth in frontier, emerging and developed markets beginning in 2000. Over this time, frontier markets GDP has grown at an annualised rate of 5.6 per cent, outpacing the growth of both emerging and developed markets. According to S&P: "Frontier market GDP growth has been higher than that of emerging and developed markets for every year since 2001." It's worth noting though that this huge growth is primarily because the countries concerned started from a much lower base - the GDP per capita of much of the developed world is roughly $37,500 compared with just $1,845 for frontier markets (and $2,390 for emerging markets).
That relative economic under-achievement is also marked in their financial services sector - most frontier markets do have stock markets (there is the odd exception such as Cambodia), but they're typically fairly difficult to invest in if you're a foreigner, heavily protected, over-regulated and subject to massive volatility.
Still, the potential is obvious - obvious enough for economists at Goldman Sachs to speculate on the countries most likely to follow in the path of the mighty BRIC economies of today. Their top candidates - called the Next 11 - included Egypt, Pakistan, Vietnam, Turkey and Iran (which is notoriously difficult to access for foreigners).
Are frontier markets a good investment ?
The big problem with all of these huge investment stories or narratives is that frequently they're precisely just that, broad stories and huge global narratives with little investment logic. Economies such as Pakistan or Cambodia may be growing fast, but will any of that rapid economic growth actually trickle down to local stock markets, and ever make it out of the country into the investment portfolio’s of investors who have financed this growth?
The risks here are obvious. The biggest and nastiest risk is of national economic meltdown - think Zimbabwe. You'll be familiar with terms like 'bread basket of Africa' and 'economic powerhouse of southern Africa' but prior to the meltdown inspired by its leader Robert Mugabe, Zimbabwe had a fairly robust stock market, open to foreign investors since 1993. In the past decade this market slumped, as economic paralysis infected all parts of the economy - national GDP is half of what it was in 2000, and is declining for the eighth consecutive year. Ever since President Mugabe's disastrous land-reform campaign, the country's farming, tourism, and gold sectors have collapsed. Unemployment is said to be near 80 per cent.
But examine this sector as a whole and you begin to see some quite powerful potential opportunities. The biggest positive are those potential returns - data from S&P shows that over the past 12 years since December 2005, $100 invested in Frontier Markets would now be worth just under $600 compared with $400 for Emerging Markets and just over $300 for Developed Markets.
Frontier markets also provide one other crucial advantage: they're poorly correlated with developed-world stock markets. Economic theory suggests that frontier markets, with their heavy commodity bias and their startup industrial exposure (refining, basic materials processing etc.) should provide low correlation to the S&P. According to analyst Heather Bell of Index Universe, that's exactly what these markets do provide as a group. The indices that track these markets sport a correlation of just 0.31 with the S&P. When Ms Bell dug deeper, she found that across the board correlation was even lower - just 0.175 between the S&P Broad Market Index and the Select Frontier Index. That low correlation makes frontier markets one of the most compelling alternative investments you can buy - provided you can take on the potential for high volatility.
How to do it
Investing in frontier markets directly is almost impossible for private investors in the UK. There are a few companies listed on the London exchange that do give you some exposure to markets such as Cambodia and Nigeria, but they’re few and far between. The more sensible alternative is to invest across the board in a wide range of countries, so that you can balance out the potential risks.
Many emerging markets fund managers are beginning to enter this space in a small way. Emerging markets guru Mark Mobius, for instance, has started buying into frontier markets through his various small-cap funds but he’s cautious. "Frontier is good if the stocks are cheap and overlooked," he told one US commentator. "Otherwise, you're better off in the bigger emerging markets... A lot of these [frontier] markets have been picked over, and their prices have already gone up... Very little money going into frontier markets can drive prices up quickly."
Many other emerging markets experts are less cyclical and as this asset class becomes more widely accepted, private investors may need to think about making a small investment in the space. Already huge fund management groups such as Jupiter have launched specialist funds that invest in key bits of the frontier space, for example, sub-Saharan Africa. One leading US asset allocation and alternative investments specialist Roger Nusbaum - you can read his blogs on www.seekingalpha.com - suggests that equity-led investors should consider a 2 per cent allocation to frontier funds as part of a globally diversified portfolio. But how do you gain this exposure? You face two simple choices, an index tracking fund or a specialist investment trust. Index tracking or exchange-traded funds (ETFs) have the advantage of simplicity and low cost, but first you have to find the right index to track.
The most popular index (the Select Frontier Index) comes from S&P and follows 22 small markets - it returned 31.62 per cent in the year to date, beating the S&P emerging market index's 27.05 per cent. This consists of 30 of the largest and most liquid companies from markets excluded from the S&P/IFCI Emerging Markets Index with companies from countries such as Bahrain, Bulgaria, Colombia, Croatia, Jordan, Oman, Pakistan, Romania, Sri Lanka, UAE, and Vietnam.
Pakistan: 28.97%
UAE: 23.12%
Jordan: 13.23v
Vietnam: 11.54%
Panama: 7.74%
Kazakhstan: 7.10%
Colombia: 6.24%
Bulgaria: 1.05%
Cambodia: 1.01%
Pakistan is not only the top country weighting but also provides the heaviest (single-) weighted company, MCB Bank Limited, while other key holdings include UAE outfits such as Emaar Properties and Aldar Properties plus a smattering of big Middle Eastern banks.
This index is tracked by a new Deutsche Bank ETF - via their DBX stable of funds - called, the S&P Select Frontier ETF (SPSFN). This pretty much does what it says on the tin, namely, it tracks the main holdings of the S&P index - the table below shows its current holdings.
This index tracker fund sits alongside Deutsche DBX's huge range of emerging market index trackers - it's also recently launched a specific Vietnam FTSE ETF (TFVTTU). These ETFs allow investors to accurately track the most liquid stocks, at a relatively low cost that range between 0.85 per cent and 0.95 per cent a year, with no initial up-front charge. But investors need to be aware that the frontier space, more than most asset classes, does require a huge amount of caution and risk control - skills that may require a more active fund management approach. ETFs may be terrifically efficient and cheap, but if they operate in intrinsically inefficient markets that are busily going nowhere, your investment could suffer.
The other big alternative is to invest in a specialised investment trust called Advance Frontiers Market run by the emerging markets team at Progressive Fund Management. This publicly-listed fund (ticker: AFMF) floated on the London market raising $85m last summer and since inception its net asset value is up just under 9 per cent. That net asset value (NAV) uplift has also proved to be lowly correlated with equity markets - as predicted - but at substantially lower volatility than expected. Its top-10 holdings are: Bank of Cyprus 14.62 per cent; Marfin Popular Bank 13.98 per cent; Muslim Commercial Bank 10.67 per cent; Kazkommertsbank 10 per cent; KazMunaiGas 8.06 per cent; Arab Bank 6.25 per cent; Copa Holdings 4.61 per cent; Suramericana Inversiones 4.41 per cent; Oil and gas Development 4.23 per cent and Bancolombia 3 per cent.
The Progressive team is led by Dr Slim Feriani, an emerging markets specialist who spotted a huge opportunity in the frontier space for an actively-managed, relatively low-cost (the management fee on the fund is 1.25 per cent a year) fund-of-funds approach. That means Progressive doesn’t directly invest in companies in frontier markets itself - it decides which countries are worth investing in at a global level, and then it finds the best-performing local funds to invest through. That gives Dr Feriani's team, aided by investment director Andrew Lister, an unparalleled overview of what they see as the world's next up-and-coming markets. I spent a morning with Dr Feriani's team discovering which countries they think our readers should be watching next. Here's their top seven countries to watch, plus Investors Chronicle shortlist of directly-quoted UK plays operating in each country.
