An intrepid trust that could defy dollar weakness

The valuations of London’s listed emerging market-focused trusts provide a clear demonstration of that apathy. Excluding JP Morgan Emerging EMEA Securities (JEMA), which had to offload its many Russian holdings following the invasion of Ukraine, the average discount to net asset value (NAV) among EM trusts is currently 11 per cent. Even the BlackRock Frontiers Investment Trust (BRFI), which boasts a sector-leading dividend yield of 4.4 per cent, is trading on a discount of more than 7 per cent. 

These figures seem out of step with the fact that emerging economies expanded last year, amid stalling developed world output. Central bankers in smaller countries will start to cut interest rates if recessionary fears arise, leading to a devaluation of their domestic currencies. But the mere whiff of a weakening US dollar – now the more likely scenario in the coming year, as the Federal Reserve embarks on a rate-cutting cycle – tends to turn investors bullish on emerging markets. This is because a more fragile greenback creates an incentive to invest in less-developed countries (thanks to a combination of lower import costs, inflation and indebtedness).

These inward flows of capital go on to benefit emerging market (EM) economies and, ultimately, their companies’ earnings. Of course, not all EMs are created equal. For example, despite recent government efforts to stabilise its struggling stock markets, foreign investors still seem wary of China (if you accept the rather dated categorisation of China as ‘emerging’, that is). 

The frenetic frontier

Many of London’s EM-focused trusts have significant exposure to the country – with the notable exception of BlackRock Frontiers. At the end of November, some 14 per cent of the group’s assets by value were concentrated on Indonesia, making it the most represented nation in the portfolio. Saudi Arabia and the United Arab Emirates follow closely behind, with 11.6 and 8.7 per cent of holdings, respectively. 

As its name suggests, the trust invests in 'frontier' economies, which are not among the eight largest in the MSCI Emerging Markets index by market cap. This rules out not only China, but also India, Taiwan, Korea and Brazil. According to analysts at Peel Hunt, frontier nations boast “growth prospects driven by domestic outlook rather than correlated to wider global markets”. But perhaps more important than the trust’s geographic allocations is its sectoral focus.

“As interest rates have risen, an overriding theme behind BRFI’s performance has been the portfolio’s financials exposure, especially Central European banks, which have seen net margins expand,” argues Peel Hunt. Warsaw-based PKO Bank Polski (PL:PKO) and the National Bank of Greece (GR:ETE) – which quality for the moniker of ‘frontier’, despite both being incorporated in the EU – feature in the trust’s 10 largest equity investments, and it also has a sizable position in Hungary’s OTP Bank (HU:OTP).

As of November, the Saudi National Bank (SA:1180) was the trust’s single-largest investment, with 4.4 per cent of net assets. The holding has proved to be a troublesome one for BRFI’s managers given the bank made a non-core investment in Credit Suisse that had to be written off last year, and which resulted in the value of the holding falling by 28 per cent in the 12 months to September. 

In its annual report, management said it was reducing its overall exposure to the Middle East by offloading some of its financial-sector holdings in Saudi Arabia. Peaking bank margins, tight liquidity and high valuations were all cited as reasons to back away. At the same time, the trust has been increasing its exposure to countries it sees benefiting from what it calls the “recalibration of supply chains”. To this end, it has initiated several positions in the Philippines. 

Given the ongoing war in Gaza and the deteriorating situation in and around the Red Sea, risk-averse investors will be glad to see the trust reducing its holdings in an increasingly volatile region. But, as with all EM investments, geopolitical threats and hard to call domestic politics are a mainstay.

The Indonesian election, due to take place in February, will be particularly consequential for BRFI. Incumbent president Joko Widodo, who has proved popular because of his market  currently looks as though a continuity candidate will win the country’s highest office, an upset could knock the country’s financial markets.

Agile allocation

Analysts with broker Numis also cite a potential resurgence of inflation, “which could stem from the impact of El Niño on food prices or further geopolitical events impacting oil prices”, as risks. However, the important thing for trusts in the sector is not that they avoid geopolitical tensions and risk (an impossible task) but that they can respond rapidly to new developments. According to analysts at Peel Hunt, this is something the BRFI team has been adept in, including the “complete removal” of large regional exposures.

In any case, many of the risks that are seen as inherent in emerging markets are present elsewhere. For instance, analysts are already speculating about the impact that a second Trump presidency could have on the US. And although neither country is an EU member, Russia’s war in Ukraine was a major contributor to Europe’s inflationary spiral. Monetary tightening in frontier economies has already outpaced developed markets, which BRFI’s managers said is beneficial, as “domestic economies should see a cyclical pick-up”. 

Countries at the top of the MSCI EM Index, such as Taiwan and South Korea, have highly developed tech sectors and a GDP to rival some of Europe’s most developed economies. The fates of their stock markets are, therefore, inexorably tied to western economic cycles. BRFI, by contrast, “offers exposure to countries seeing rapid GDP growth and experiencing development from a rapid base” notes Kepler Trust Intelligence. 

The track record is also strong. Over five years, BRFI’s NAV total return of 49 per cent is significantly ahead of the MSCI Emerging Markets Index’s 20 per cent. In 2023 alone, its NAV total return was 14.3 per cent in sterling, while the index was up just 2.2 per cent. Although its discount has narrowed in recent months, we’d argue that this prior history of outperformance means BlackRock Frontiers remains undervalued. Whether the trust is truly untethered from the fates of the world’s major economies remains to be seen. But it could certainly provide equity investors with a sought-after element of diversification.