Both portfolios have benefitted from exposure to emerging markets over the years. However, this exposure has tended to focus on the more 'established’ markets such as the Brics (Brazil, Russia, India, China). It has also looked to gain income, and this remains an attractive theme. However, in February I increased exposure in the growth portfolio to the so-called 'frontier' markets - believing now is an attractive entry point on a longer-term view.
The opportunities and risks
Whether you have visited some exotic or 'remote' countries in your travels, or read Vijay Mahajan's book The Arab World Unbound or simply follow the news, one cannot help but notice that progress abounds in the far reaches of the world - in those countries presently beyond the investment mainstream. Globalisation is on the march in these frontier markets. It will not be a smooth journey, but it will be a journey that throws up many opportunities. The challenge for investors is to know how best to profit.
The MSCI Frontier Markets index contains around 30 countries. But in reality, the definition of a frontier market extends to any country which is not either 'developed' or 'emerging' - and takes in countries from Azerbaijan to Zambia, and Argentina to Zimbabwe. These countries do indeed represent the final frontier when it comes to investing.
The case for frontier countries is relatively straightforward. They contain many of the fastestgrowing economies in the world. Many of these governments have low debt levels, rich commodity reserves and a growing determination to provide a higher standard of living for their peoples - if only because some regimes need to reinforce their position in the absence of democracy.
But a particular attraction with these frontier economies is their young populations. Not only are these countries home to around a third of the world's population, but these populations are young and rapidly expanding with money to spend because of economic progress. For example, Nigeria – one of the darlings of the frontier markets at present - has a population of around 160m with an average age of 18, compared with an average age of 40 in the UK.
The consumer theme is relatively well established in the mainstream emerging countries. Industrialisation and economic progress are resulting in hundreds of millions of people across the globe acquiring new-found wealth. These burgeoning middle classes have tremendous disposable income to spend. But investors risk under-estimating this trend among frontier economies – the urge for people to lift themselves out of poverty is rightly a very strong human instinct.
Vietnam is the world's 13th most populous country with 90m people, yet it is ranked around 130th in the world when it comes to GDP per capita. But incomes are rising rapidly. Other countries in the same position - large populations but relatively low GDP per capita – include Nigeria, Kenya and Egypt. Yet when looking at the ratings of local companies looking to capitalise on this theme, whether they be retailers or banks, they tend to be much cheaper than companies in the more established 'emerging' markets.
Therein lies the opportunity for investors. Frontier markets are still relatively cheap. Approximate estimates suggest that they are on around 10 times earnings, compared with 12 times for emerging markets and 15 times for developed markets. Frontier markets remain around 40 per cent below their 2008 peak - towards the bottom of their recent five-year range of seven to 17 times earnings.
Furthermore, many of these markets are at the very early stages of development - they are typically under-researched and under-owned. Not only does this present fertile ground for good fund managers, but these markets are where emerging markets were 10-20 years ago – when they were still a niche asset class and not a mainstream investment. Frontier markets will follow the same path.
And investors who get in early will be disproportionately rewarded. This happened in markets such as Brazil and Russia before they became more mainstream. £10,000 invested in MSCI Brazil in July 2002 would be worth around £8,000 today – this figure drops to £1,300 had you waited to invest until July 2007.
No one can say whether the ratings of frontier markets are similarly poised to expand, but it will come - if it is not on the horizon already. As with many other aspects of investment, the patient investor will be amply rewarded. The global investment industry is very underweight. Estimates suggest there is around $1,000bn (£660bn) invested in emerging markets, compared with just $10bn in frontier markets - which has helped to keep valuations down. The effect could be dramatic once the weight of money shifts.
A further attraction with frontier markets is their reduced correlation with the more established markets - many did not fall at all in 2008. And the lack of correlation between frontier markets themselves has had a smoothing effect on the asset class as a whole. Indeed, many investors expect massive volatility - and some individual markets do oblige - but, taken as a whole, the volatility has been half that of the FTSE 100 index in recent years.
There are of course risks. Political instability, lack of liquidity, government and corporate corruption are key among them. The lack of liquidity would be less of a problem if it were not for the political and corporate governance risks. Developments suggest that many of these countries are slowly moving in the right direction. But these risks reinforce the need for investors to adopt a buy-and-hold strategy - which fits in with the investment philosophy of both portfolios.
Portfolio changes
I have introduced BlackRock Frontiers Trust (BRFI) into the growth portfolio. BRFI has performed well since its launch a few years ago. Sam Vecht, its fund manager, says that the portfolio trades on about eight times earnings, which is at a discount to the MSCI Frontiers index. This is because he is careful not to overpay, believing valuation is a proven determinant of returns. Although trading close to net asset value (NAV), BRFI promises to redeem all shares at NAV in three years' time which should keep the discount reasonably tight. An added attraction is that it comes with a 2 per cent+ yield - although income is not its first objective.
The purchase was funded by selling North Atlantic Smaller Companies (NAS) and top-slicing Utilico Emerging Markets (UEM) - both having made decent profits. Following my column last month ('Japan: A once in a lifetime opportunity,' 8 February, 2013) I have also added to the growth portfolio's holding of Baillie Gifford Japan trust (BGFD).
Once again, there were no changes to the income portfolio.
