- What are Frontier Markets Spring 2008.pdf
- Longer PDF version of article
Where are the next Frontiers for Global Investors ? .....
If you’d have seriously suggested to private investors twenty years ago that they invest a substantial portion of their portfolio in the BRIC countries – emerging markets such as Brazil, Russia, China and India – they’d have probably thought stark raving mad. Back then emerging markets were not only insanely risky but also hugely inaccessible for private investors. Not anymore - hundreds of emerging markets companies are now directly listed on either the US or UK main markets and funds that invest in emerging markets number in the hundreds - what was quite literally once forbidden in some countries (foreign equity ownership via freely traded shares) is now ever so slightly passé. The BRIC mega-caps like Gazprom from Russia or Petrobas from Brazil are now 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 UAE and Mongolia. This ‘second division’ of smaller, faster 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, are 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 on earth are ‘Frontier Markets’!
Frontier markets comprise roughly one billion people, and about $2.4 trillion of global capital. Defined loosely by international bodies like the World Bank, frontier markets are high-risk, low-income countries. They’re typically
- difficult to access for outside investors
- fairly risky on the political (and economic) front
- and they have the potential for huge returns and even bigger declines.
According to analysts at S&P – they have their own Frontier indices - frontier market economies have been growing at a “brisk pace since 2000”. The graph below shows the average real GDP growth in frontier, emerging and developed markets beginning in 2000. Over this time, frontier markets GDP has grown at an annualized rate of 5.6%, 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”. To be fair 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 to just $1845 for Frontier markets (and $2390 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 in fact 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 even 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 actual investment logic. Economies like Pakistan or Cambodia may be growing like gang-busters but will any of that rapid economic growth actually a) trickle down to local stock markets, and b) ever make it out of the country into the investment portfolio’s of investors who have financed this growth?
The risks here are fairly 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 stockmarket, open to foreign investors since 1993. In the last 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 currently declining for the eight 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%.
If you take one step back from just looking at Zimbabwe and examine this sector a s a whole - motley basket cases, potential economic hot spots plus the odd Axis of Evil member in the guise of Iran and North Korea - you can begin to see some quite powerful potential opportunities. The biggest potential positive are those potential returns - the graph below from S&P shows returns over the last decade from both Frontier and Emerging markets as an asset class. Over the last 12 years since December 2005, $100 invested in Frontier Markets would now be worth just under $600 compared to $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. If you look at the indices that track these markets they currently sport a correlation of just 0.31 compared to the S&P. When Bell dug even deeper into the figures 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’re willing to stand the potential for high volatility.
