Finding the efficient frontier - asset managers look beyond emerging markets

There is one certainty about investing in frontier markets. It means travel. Lots of it. Today Mark Mobius, manager of Franklin Templeton’s Frontier Market fund, is in the Philippines but he could be in any one of the 30 plus countries the fund invests in.

Mobius, nominally a Singapore resident but more often than not on the road, chuckles down the phone line when asked how many miles he travels in the course of his job. “Oh, it’s 1000s – I must go around the world at least three or four times a year.”

And it is not just Mobius who is getting well-acquainted with airport departure lounges. Franklin Templeton has $1bn of asset under management in its frontier funds and is the biggest player in the sector – but far from the only one.

As advanced economies stutter, frontier markets are booming driven forward by the combined effects of favourable demographics, abundant resources, and low levels of state debt.

For Daniel Broby, chief investment officer at boutique frontier specialists Silk Invest, the juxtaposition of these factors is compelling. “Combined, these trends result in above average growth. And that isn’t just talk.”

Fundamentals

The increasing focus on frontier markets is a natural extension of the pursuit of alpha – what better way to get above average returns than by investing in places the average fund manager does not go?

Crucially, the returns from frontier countries are not completely correlated with those of developed markets. Diversification failed investors in the 2008 financial crisis, with virtually all asset classes hitting a correlation of one – but frontier markets have shown a greater decoupling from the global economy.

In 2009, for example, Central Asia saw growth of nearly 5% when the global economy as a whole contracted by 1.2%, according to Silk Invest. Top of that year’s global growth class were Qatar (18.5%) and the Republic of Congo (9%); in each case abundant natural resources were the driving force behind economic expansion.

But frontier market investment is not just a resource play – demographics and debt levels are also more favourable than among developed states.

As the West wrestles with how to meet the costs of an aging population and a consequently shrinking workforce, frontier markets are characterised with strong population growth – in Nigeria, for example, 40% of the population is under 20.

Correlation

Given frontier markets include states as diverse as Nigeria, Argentina, and Qatar, defining the term is a challenge.

MSCI uses a free float-adjusted market capitalisation approach for its Frontier Market Index that is designed to measure equity market performance of states, including the three previously mentioned countries, plus a hotchpotch of 22 others such as Kenya, Sri Lanka, and Kazakhstan.

According to Mobius this diversity is frontier markets’ main strength – moves in the direction of one country can be expected to balanced out by changes in others.

Take the example of Ghana and Kenya, both sub-Saharan African states of similar size, with large agricultural bases, yet in the first week of July, the former lowered its interest rates while the East African state raised its. 

“There is very low correlation in our portfolio,” say Mobius. 

“This is not only true between the frontier markets Franklin Templeton invests in but also between the portfolio itself and developed markets. And that’s a very attractive attribute”, he says.

Low correlation does not mean no correlation and Andrew Brown, London-based Europe Middle East and Africa (EMEA) investment manager, at Aberdeen Asset Managers, cautions not to be to optimistic over how these relationships will play out in difficult economic times.

“One of the main attractions of investing in frontier markets is the additional diversification between them and developed markets, but in a crisis situation these become a lot closer.”

Political risk

Another facet of frontier markets is that investing in them comes with political risk. While democracy is spreading across countries in this asset class – the last decade as seen a four-fold increase in the number of elections held in frontier states – investing in any country without a strong rule of law leaves firms exposed.

For Broby this risk means it is vital to have a diversified portfolio. “That’s why people talk about frontier markets as an asset class. If you went in and bought a 100% of your assets in Saudi Arabia you would be really exposing yourself to political risk,” he says.

The CIO’s belief in the power of diversification is shared by Henrik Kahm, Stockholm-based fund manager for FMG’s Iraq Fund.

The Swedish boutique investor has been working in emerging markets from its founding in the late 1980s, and has been active in MENA since 2007 when equity markets in the region fell. And while Kahm is a strong believer in the growth prospects for investors in Iraq he is upfront about the pitfalls.

“FMG offers 10 equity funds and we only get investors to allocate 5-10% of their capital into the Iraq fund – it is a high risk investment”

MSCI

On obvious example of this is its near neighbours Qatar and the United Arab Emirates, which MSCI refused to upgrade from frontier to emerging market status in June this year due to onerous restrictions on foreign investment by the two Arab states.

In Qatar, for example, foreign ownership of any firm on the local exchange is limited to 20%, while investment in Qatar Industries, which makes up a quarter of the index’s market capitalisation, is capped at 5%.

But according to Kahm Iraq is far more open to international capitalism totally open to international investors.

“The lack of foreign ownership limits makes Iraq very different to other frontier markets”, says Kahm.

“If you look at Vietnam, Tanzania, UAE, and Qatar to highlight just a few examples, you will find different sectors that are important to the government where foreign ownership is capped at 20% or 40%. There’s none of that in Iraq.”

Another reason Kahm is bullish about Iraq’s investment potential is that the Iraqi dinar is fixed to the dollar, making moving money in and out the country easier than in other frontier markets.

Iraq is an outlier with respect to having its currency pegged to the dollar; investing in  frontier and developing markets usually comes with foreign exchange risk.

For this reason Aberdeen Asset Management does not invest in any firms that have significant exposure to foreign exchange movements or large amounts of foreign debt.

Issues of cost mean that is does not hedge-out the FX risk in the fund either, an approach echoed by Mobius.

“We don’t hedge FX because our exposure is long at over five years, and it would just get very expensive to hedge this, even if was possible to do so. Instead we look at how firms are exposed to FX risk and ask them how they manage exposure.

Some will be hedging themselves. So, rather than trying to hedge the currency directly, we do it indirectly via the company itself.”

Operational challenges

The necessity of speaking to companies on the ground is a recurring theme of frontier market investors. Indeed, Brown describes it as one of the key operational challenges of investing in this asset class.

“To do long-term investment in frontier markets you must do your due diligence and meet the management – generally these firms are poorly researched so the only way to overcome this issue is to get out and meet them”.

That said, getting to meet local management may be more difficult than you would expect. Despite being termed frontier by external investors many markets contain companies which have traded profitably for long time, in some cases hundreds of years.

Convincing these firms that they need additional capital from a fund manager whose firm is based thousands of miles away is more difficult that you would expect, according to Brown.

“Investors need to be on the ground. But that said, companies in areas where capital markets are nascent – and local firms may not be used to international investment – might not want to speak to you”.

According to Andrew Tymms, Johannesburg-based partner for consulting firm Bain & Company, firms – in Africa at least – are now much more receptive to international investors than was previously the case.

Pointing to a $1bn Africa fund set-up by private equity firm Carlyle this year, one of several now operating on the continent, he says this is indicative of the increasing willingness of local management to take-on outside investment.

“Due to a lack of knowledge and experience of international investors some African companies may have been unwilling to engage with frontier investors but this is much less the case now.

Traditionally Africa was purely about resources but a combination of economic expansion and technological advances mean that both telecoms and retail firms are providing some interesting opportunities,” says Tymms.

Africa

Broby is also bullish about Africa, Nigeria in particular (see box). He also sees big opportunities in Saudi Arabia as, despite not being affected by the financial crisis in 2008, it still responded with a fiscal stimulus equal to 3% of its GDP. 

Currently foreign investors cannot get direct exposure to Saudi equities and have to instead carry out swaps with domestic banks – p-notes, or participation notes – which provide the economic exposure without direct ownership.

But Broby says this is set to change, referring to positive recent talks he says, “We believe an announcement is on opening the Saudi Arabian equity markets to foreign investors is close.”

Others are more sceptical. One person with extensive experience of the region’s capital markets thought things could take longer.

While he was positive that Saudi Arabia will open up to international investors at some point, given the recent turmoil in the region he thinks expecting this to happen in the near future is “wishful thinking” and “we’d like to see the change but we are not expecting it in the near future.”

The issue of timing is at the heart of the frontier investment story. Demographics are in their favour and they hold a large share of the world’s resources at a time when competition for these has reached historical highs. Frontier markets look set to grow in dramatic fashion. 

But according to Aberdeen Asset Management’s Brown, while this long-term trend is clear, what happens in the near future is less obvious.

“Over the next 50 to 100 years frontier markets will expand in a meaningful way. The question of what will happen to them over the next six or seven years is much more difficult to answer.”