Frontier markets, which include the likes of Argentina and Sri Lanka, are potentially lucrative because they’re at a relatively early stage of their development.
However, the political and economic backdrops of these countries can also be unstable, which means investors need to prepare themselves for a rocky ride.
This means frontier markets won’t be for everyone, according to Juliet Schooling Latter, research director at Chelsea Financial Services. The positives, she suggested, include a low correlation to other asset classes, very good demographics and plenty of under-researched companies.
“The downside is that they are extremely high risk,” she added. “Funds specialising in this area can still be quite expensive.”
Why consider frontier areas?
The macro fundamentals and demographics resemble those of the emerging countries 20 years ago, according to Oliver Bell, manager of the T.Rowe Frontier Markets Equity fund.
Those emerging markets have performed fantastically well over the last few decades so the chance of enjoying a repeat performance is going to be attractive.
The IA Global Emerging Markets sector has risen 66.65 over the past decade, according to figures compiled for us by Morningstar for the 10 years to 12 December 2017.
However, the headline figures obscure winners and losers with the top funds delivering a return of more than 170% over this period – and the worst down by more than 20%.
This illustrates the rather unpredictable nature of these parts of the world and the fact that performance can vary enormously between countries, sectors and fund managers.
Although frontier areas are at an even earlier stage than emerging markets in their development, and likely to be even more volatile, they can also offer fantastic opportunities.
What do fund managers look for?
Dominic Bokor-Ingram, who runs the Charlemagne Magna New Frontiers fund with Stefan Böttcher, wants to see evidence of economic and political reform.
He believes this helps generate economic growth, which provides the perfect backdrop for companies and investors to make money over time.
“It has to be a combination of top-down factors and bottom-up fundamentals coming together,” he added. “You then have to buy the shares at the right valuations.”
Their fund focuses on domestic growth stories. In sector terms, this translates as companies involved in utilities, banks, healthcare, and education.
“It’s anything that can take advantage of the rising incomes of local populations,” he said. “We also focus on the corporate governance of individual stocks.”
This is particularly crucial.
“If you run the company correctly then more people will buy your shares and then their price will rise,” he added. “Should you want to raise new money, your cost of capital will be lower.”
A golden rule is never to invest in a company if you haven’t met their management team at least once. “We need to believe they can not only take advantage of the growth opportunity but that they’re running their company in the right way,” he added.
Political improvements, stability, institutional developments and an environment of confidence are key for Andrew Brudenell, manager of the Ashmore Emerging Markets Frontier Equity fund.
“The big factor for us is the management teams,” he said. “We need to understand what they are doing from a capital allocation point of view.”
Does the company have a good quality business model? Is it able to generate returns above the cost of capital? How strong is the balance sheet?
Which frontier areas are most exciting?
Georgia, Bangladesh, UAE and the Ukraine have been among the better performing frontier regions, according to Brudenell.
“Argentina and Pakistan (which has been reclassified to emerging market status) have been our biggest exposures because their structural developments have been conducive to business growth and investment,” he said.
T.Rowe’s Oliver Bell still has decent exposure to Argentina as he believes in its structural story. Romania's rising wages and low inflation are supportive to our brand names, while banks are benefitting from an improved credit backdrop.
“We view opportunities in Sri Lanka as relatively overlooked and valuations are decidedly cheap despite there still being high-quality management in place,” he added.
Its location adds to its attractiveness and potential. “Recent infrastructure projects, including port developments, are likely leading to a construction boom and there are some good stocks in which to play this,” pointed out Bell.
Elsewhere, frontier Asia is seen as exciting. “Vietnam is steadily growing exports to levels consistent with many developed countries, especially as regards mobile phones and devices, while a young, highly productive middle class continues to emerge,” he added.
Who should have exposure?
Patrick Connolly, a certified financial planner with Chase de Vere, believes exposure to such markets is only suitable for those willing to take a high degree of investment risk.
“They are most appropriate for investors that are prepared to take a long-term approach and won’t be unnerved if their holdings suffer significant short-term falls,” he says.
Social and political dangers, a severe lack of infrastructure and poor corporate governance within companies are among the problems investors can face.
“You might not be able to trust what is in the company accounts, while limited liquidity in most shares can make it difficult and expensive to trade in reasonable quantities,” he said.
Anyone getting involved, he argued, needed to be prepared: “Investors in frontier markets can expect continued volatility, meaning there is scope to make significant gains or large losses over very short time periods,” he added.
How to get involved
Connolly doesn’t believe in buying solely frontier-focused portfolios but acknowledges there are other ways to get involved.
“Investors can benefit by investing in western-listed companies that do business there and global emerging market funds where fund managers may dip into frontier markets,” he added.
Schooling Latter at Chelsea Financial Services agreed most investors are better off sticking to such funds, but acknowledged there are options for the more gung-ho investor. “Funds we like are T.Rowe Price Frontier Markets equity, Charlemagne Magna New Frontiers and, for a slightly wider play, RWC Emerging Markets, which can have up to 20% invested in frontier markets,” she said.
It all comes down to how much people want to invest – and how much they can afford to lose if the markets went downhill.
“A small allocation may be beneficial to investors with larger pots of money wanting to add higher risk at the edges for potentially higher returns,” she added. “It’s also an investment for the very long-term.”