Capital Group’s Richard Carlyle weighs the pros and cons of frontier investments
Richard Carlyle, investment specialist at Capital Group, sees scope for frontier markets to add diversification for investors keen on exposure to higher growth economies.
As emerging markets have become more mainstream in recent years by becoming increasingly regarded as a core portfolio allocation, many investors have found themselves considering frontier markets as the next ‘big idea’. These are widely considered as the under-researched, higher growth opportunities that could be the next emerging markets in waiting. As key emerging markets make the transition to developed status the rationale is that these newer markets will fill the void left by the likes of Mexico or Brazil.
Although the definition of frontier markets is somewhat vague and classifiers may disagree about whether some markets are frontier or emerging, the term generally refers to markets that are at the earliest stages of economic development and do not yet have established financial markets. MSCI offers an index composed of 32 smaller developing markets throughout the globe, concentrated in the Middle East, Africa and Eastern Europe. The aim of the MSCI Frontier Markets Index is to help provide investors with “expanded opportunities beyond traditional and developed emerging markets,” according to MSCI Barra.
Frontier market equities have delivered strong gains so far in 2013. In an environment where emerging markets year to date have fallen 9.6% in US dollar terms, the MCSI Frontier Market Index has delivered returns of 11.1% in US dollar terms – among one of its best performances, since the index was created in 2007. Countries such as the United Arab Emirates, Bulgaria and Kenya have delivered gains of above 25% in local terms this year to date (source: RIMES). However, this is no indication of future returns in frontier markets.
Frontier markets have the potential to offer attractive investment opportunities. But with that potential reward comes risk – frontier markets face additional risks, given the lack of infrastructure and safeguards that investors are accustomed to in more established markets; they also tend to be smaller and less liquid than more developed markets.
Many frontier markets have systems of government in place that can be prone to instability. For example, political risk remains an obstacle to rapid economic development in several resource-rich frontier markets such as Nigeria. In addition, four of the largest countries within the Frontier Markets Index are members of OPEC and are therefore subject to oil price risk. Turmoil can in turn translate into stock market volatility for securities traded in impacted countries.
At Capital, we do not currently regard frontier markets as a separate, dedicated asset class. Instead, we believe accessing frontier markets as part of a broadly diversified emerging market portfolio rather than as an individual asset class offers an alternative way to capture investment opportunities in these markets, but with lower volatility.
A broad approach offers the flexibility to invest in the debt as well as equity of smaller developing markets. Bond markets generally develop before equity markets, especially sovereign debt opportunities in international currencies, as trading and settlement in these markets tends to be easier. For example, Belarus – which is a well-diversified economy with low fiscal needs – is difficult to access through equities, but the country does issue bonds.
Emerging market debt markets have a total investable market capitalisation of about $1.2 trillion, according to JP Morgan, with African bond markets offering about $35 billion in investable debt and the Middle East totalling about $73 billion. Substantial amounts of corporate debt are issued in the Middle East, with corporate debt issuance in Qatar and the United Arab Emirates at about $18 billion and $23 billion, respectively. Moreover, investing in international dollar bond issues, where settlement, clearance, taxes and repatriation are not obstacles, is a viable way to access these markets at the initial stages of development.
In addition to direct investments in select frontier market stocks, emerging market equity portfolios can also provide indirect exposure to many frontier markets through investments in companies that have significant exposure to the frontier market economies. For example, it is possible to have exposure to companies with their primary operations in places as far flung as Greenland, Papua New Guinea, Angola and Kazakhstan – but they are listed in the UK, Australia, Portugal and Canada.
Frontier markets have investment opportunities that may offer the chance for greater returns than more mature emerging markets. The benefits of investing in these regions have increasingly attracted the attention of many investors; however we believe investors should remain vigilant about the risks involved.
Broad long-term exposure to rapidly growing economies throughout the world can be achieved without investing solely in a dedicated frontier markets mandate, offering the chance for better risk-adjusted returns, in our view.