Veritas: eight challenges when investing in Frontier markets

Frontier markets hold out the promise of extra returns, as if there is a proportional connection between risks taken and achieved returns.

But Frontier markets come with their own set of challenges. Among them are:

Size. This is not directly to do with geographical size or demographic potential, although those may be factors. This refers to the size and depth of the financial market. Small markets are difficult for bigger investors, because their impact is too great.

Liquidity. Frontier markets may offer an attractive potential return, but investors may be locked into their positions for some time because the volume in Frontier markets is very low and it is difficult to transact without moving the price against themselves.

Distance. From both the home base of the investor and the core of the portfolio. Frontier markets are likely to be considered optional extras, and will be the first to be sold, through no fault of their own, if investors needs to retrench to their home base or core portfolio for any reason

Political risk. Frontier markets by their nature have weaker political, social and financial infrastructure, which may produce surprises when under pressure. The lure of any special opportunity may be diminished when the range of geo-political and social risks are lined up against it. It takes a mature and far sighted government to walk the line between welcoming foreign investment, and condemning foreign “hot capital”, and between listening to market advisors and retaining centralised control.

Benchmarks. Institutional and larger wholesale investors may be interested in Frontier markets, but soon come up against the limitations of their own investment framework, which precludes positions in markets not included in specific benchmarks. Freedom from this constraint is a major advantage for independent sophisticated investors or the sovereign wealth funds.

Internal investor base. Nascent markets are often characterised by a thin domestic investor base. A few individuals control a large proportion of the country’s wealth, leaving international investors vulnerable to the interests of a clique. A broad base of domestic investors is reassuring for the outsiders, as it indicates a higher level of governance and also a potential exit in the future.

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