Wednesday, January 18, 2012


Fears of a Western financial meltdown are giving frontier markets a new lease of life

By Lucy Fitzgeorge-Parker

Putting together a well-balanced portfolio has never been easy, but until recently there were at least some certainties investors could rely on. If you wanted a sensible, low- risk investment with a reasonable rate of return, you bought developed-world government bonds or blue-chip stocks; if on the other hand you were prepared to lose your shirt in pursuit of stratospheric profits, you opted for equities from Africa or other exotic destinations.

In the three years since the collapse of Lehman Brothers, however, all that has changed. Not only have many so-called ‘frontier markets’ made giant strides in economic development, but – with contagion from countries such as Ireland and Greece threatening core European markets and the US suffering a sovereign downgrade – the concept of ‘risk-free’ investments has had to be consigned to the dustbin of history.

“Risk-free assets don’t exist and never did, so if you have 90% of your net worth in Europe and the US you’re actually taking a massive gamble,” says Jerome Booth, head of research at specialist emerging markets fund manager Ashmore. “All countries are risky – the difference is that in frontier markets the risk is priced in.”

What is more, frontier markets currently offer something even more valuable for investors and almost non-existent in the developed world – growth. Since the financial crisis, Western economies have been struggling to break free from recession and this has been reflected in near-zero interest rates and wildly volatile stock markets. By contrast, frontier markets such as Sri Lanka, Nigeria and Iraq were barely affected by the global downturn and should post annual GDP growth of more than 6% for the next five years, according to IMF forecasts.

Yet while the risk-reward profile of frontier markets may be looking ever more appealing, gaining exposure to them can still prove frustratingly hard for Western investors and money managers. Indeed, lack of access – whether for reasons of size, liquidity or regulation – is one of the key characteristics that make a market frontier, as opposed to emerging.

Thus the most widely used frame of reference for this equity space, the MSCI Frontier Markets Index, includes tiny EU member Estonia and ultra-wealthy Gulf states such as Qatar that restrict foreign ownership of assets, as well as more obvious choices such as Lebanon, Pakistan and Ukraine. And in the broader frontier universe – usually defined as any of the 100 or so countries that are neither emerging nor developed – a much-hyped new market such as Mongolia can have a daily stock-market turnover of less than $60,000.

This lack of liquidity limits the extent to which larger funds can get involved in frontier markets, partly because of the lack of stocks to buy and partly because purchases of any size will tend to move the market. Yet as veteran asset manager Mark Mobius – who oversees $50bn of emerging and frontier-market investments for Franklin Templeton – explains, the biggest hurdle for funds is often something as simple as the lack of reliable custodian banking. “Unless we’re able to safekeep our securities with a really good custodian, then there’s no way of getting in,” he says.

This limitation means larger firms such as Franklin Templeton are unable to get direct access to many frontier markets – although, as Mobius points out, scale can have its advantages. “As we’re a pretty big money manager, the custodians make a lot of money on our regular funds and we can twist their arm a little bit,” he says. “We can say, ‘Look, we realise that you’re not going to make a ton of money in Laos or Cambodia but we need that, and if they can do it they will accommodate us.”

And there are alternatives to direct investment. In Mongolia, for example, many of the companies that stand to benefit most from its mineral wealth are based in – or listed on the stock markets of – the UK, Canada or Australia. Thus investors can gain exposure to frontier markets’ most lucrative sectors while enjoying the protection of developed- world regulation and corporate governance – not to mention much lower transaction costs. “If we had two companies, one listed in London and one listed in Cambodia, but the London one was more liquid, we would probably favour that one, all things being equal,” says Mobius.

Yet as Arild Johansen, chief analyst at boutique frontier specialist FMG, points out, there are disadvantages to investing indirectly. “The problem with the offshore listings is that they follow the sentiment of the West,” he says, “so if you have a massive correction going on there, these stocks will obviously go down with it because people don’t really care what the underlying drives are. When you invest locally you are cushioned from all that.”

For this reason, he argues, when it comes to frontier markets, “small is beautiful”. Iraq’s nascent stock market, for example, has shown impressive returns over the past two years but is still off-limits to large firms such as Franklin Templeton because of the lack of liquidity and a global custodian – whereas smaller player FMG was able to move into the market as early as May 2010.

“It gives the boutiques a way to go into exciting areas before the big funds consider them,” Johansen adds. “And it gives us time to build a nice position and be there with real money and a good chunk of the money by the time they find it interesting so they can take it up to the next level.

To us it’s important to get started early in these markets as most returns are made in the initial part of the curve.”

Slim Feriani, CEO of boutique manager Advanced Emerging Capital, agrees that first-mover advantage is a key attraction. “The commonality across all the frontier markets is that they are probably the most under-researched and underinvested countries globally. That’s where the opportunity is because that can only change,” he says. “You’ll have more people investing in them, and if you have moved in before the crowds, then typically all the boats will get lifted at one point in time.”

There are, of course, downsides to going down the boutique route, as investors in several smaller Africa funds found in 2008 – when the credit crunch hit, ‘hot money’ deserted the frontier space, forcing funds to sell out at a loss and ultimately close. For this reason, managers of open-ended funds are at pains to stress that frontier should be seen as a long-term investment. “We try to make sure investors understand that when you buy into, say, Iraq, that you should have at least a five-year horizon on your money and look at it as a liquid private- equity investment,” says Johansen.

And events of the past year suggest investors have taken this message on board. As Ashmore’s Booth points out, when political turmoil engulfed the Middle East and North Africa (MENA) in the spring, emerging-market equity funds saw substantial withdrawals by the US retail- investor base but, for the most part, frontier funds were unaffected. “The hot money that poured into frontier markets in 2007 and 2008 came out and never came back again,” he says. “These days when a crisis seems to be looming, there isn’t a massive rush for the exit because the people invested in frontier aren’t fleet of foot.”

What some analysts fear could spark a panic, given the preponderance of commodity-rich economies in the frontier space, is the much-touted prospect of a hard landing in China. “As long as growth overall doesn’t slow dramatically and commodity prices remain at similar levels to where they are today, then frontier markets are in excellent shape,” says Johansen. “But if, God forbid, China should slash into growth to absolutely nothing and their appetite for commodities dropped accordingly, then these economies are extremely vulnerable to that.”

Most frontier managers, however, dismiss such fears as overdone – Mobius says speculation about problems in China is driven by hedge funds talking their own books, while Ashmore’s Booth points out that even after a major correction, emerging markets would likely still show growth rates well above anything imaginable in the West. “Yes, one needs to be concerned about commodities, but if you’ve got something big enough to really cause you to be worried, then you want more frontier markets and you want to have nothing in the US or Europe,” he says.

Mobius also insists that the concept of frontier markets as pure commodities plays is misguided given that – as, for example, in Nigeria, a resource-rich country and one of the fastest-growing economies in the frontier space – both the firms that control the sector and the money made from it are frequently kept outside the jurisdiction. “I wouldn’t say frontier investors need to be bullish on commodities, I would say they need to be bullish on the growth of consumer markets,” he says.

For him, the most exciting recent development both in Nigeria and other markets such as Vietnam is the move towards privatisation of utilities, which provides a large investor such as Franklin Templeton with a rare combination of scale, regulatory security and exposure to an infrastructure boom he sees as inevitable. “On average, including all the basket cases, emerging and frontier markets are growing three times faster than developed countries and that means there’s demand for everything,” he says, citing his own recent experience of being twice stuck in an elevator in Lagos due to power outages.

Feriani at Advanced Emerging Capital agrees that consumer stocks – typically dominated by sectors such as finance, telcos, retail, food and beverage, and infrastructure – offer the best opportunities for frontier investors, giving access to the growing middle class and providing some insulation from events in developed markets. “We prefer to be exposed to the domestic sector in these rapidly growing economies because the export sector remains vulnerable to what happens in the West for the time being and how the Western consumer behaves,” he says.

Indeed, lack of correlation with both the rest of the world and each other remains one of the key appeals of frontier economies – particularly after three years of repeated convulsions in the core markets of Europe and the US. As Feriani points out: “Many of these countries are actually negatively correlated with each other – if you have an event in Tunisia you don’t expect contagion from that in Vietnam, and what happens at the macro level in Qatar doesn’t necessarily have anything to do with what’s happening in Argentina.”

Some frontier advocates go even further. “Even if the fundamentals in the US and Europe are getting really bad, there are always going to be pockets of investors with money to spend and it’s not absurd to think that many of them might start looking at the better-managed frontier markets as safe havens over the next five years,” says Peter Bartlett, managing director of frontier-investment bank Exotix. He cites the example of Dubai, which saw huge capital inflows during the MENA region troubles this year, and Mauritius, which has already achieved partial safe- haven status for African investors.

For Mobius, the biggest challenge is overcoming outdated investor prejudice. “It’s beginning to dawn on people that the perception of risk is changing – but it’s going to take a long time because it’s very difficult to explain that if you really want to be safe, you’ve got to be diversified, and the way to diversify is to get out of your own country and invest globally,” he says.

Booth at Ashmore agrees that frontier markets stand to benefit from a paradigm shift on the part of investors in the near future. “As the perception of risk and the perception of macroeconomic factors filters into the heads of big institutional investors, it’s going to radically change the way they view the world and the way they think about asset allocation, and that’s naturally going to lead to more allocation to emerging and frontier markets,” he says.

If they are right, frontier’s early adopters could yet be the big winners of the next investment cycle.


For risk-hungry investors, the news that frontier markets are becoming safer by the day is far from welcome. Fortunately for such souls there are still economies at the extreme edge that offer the prospect of huge returns and equally large losses.

Countries such as North Korea, Cuba and Zimbabwe offer what is known as an ‘event risk’ profile. As Peter Bartlett of Exotix explains: “You buy into these economies because, while it’s very hard for you to say what the right value should be on those assets at the moment, you know that there is an event in each of these countries that will stimulate a massive surge in demand.”

In many cases that event is the removal or death of whoever is in power. For North Korea it would be the signing of a reunification treaty with its southern neighbour.

Gaining access to these markets is not easy but several have outstanding bonds, and in Zimbabwe stocks such as drinks- maker Delta and telecoms firm Econet offer upside potential. Advanced Emerging Capital’s frontier fund has a 3% allocation, and CEO Slim Feriani sees it as a long-term play. “We don’t expect Zimbabwe to become a South Africa overnight but in situations like this one, the impact of any positive change on returns from an equity-market point of view could be massive,” he adds.


Frontier’s next hotspots

Mark Mobius, Franklin Templeton


“Laos has just opened its stock exchange and we’re looking at that, and there are places that in the past we were invested in and we’ll go back into, such as Bangladesh and Sri Lanka. Before the recent upheaval we were invested in Libya... I would say we’ll be back there within a year.”

Peter Bartlett, Exotix


“If the smaller English-speaking Caribbean islands could pool their list of companies into one stock market, you’d have some interesting opportunities. Kazakhstan and Kenya lost a third of their value this year... At some point they will bounce back.”

Arild Johansen, FMG


“Rwanda is a booming economy – they’ve just set up their capital markets and they’ve started listing some companies. Ghana recently became an exporter of oil and is growing tremendously – and it doesn’t just have oil, it also has other commodities such as cocoa, coff ee and gold.”

Jerome Booth, Ashmore Investment Management


“We’re bullish on Nigeria, particularly the financial sector. Places such as Zambia offer commodities exposure and have always been very well run. We’ve got almost 5% of our frontier market fund in Botswana, and there are things in Zimbabwe.”
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