Search in book...
Toggle Font Controls
Create new playlist

Name your new playlist

Playlist description (optional)
Sign In

Email address

Password

Forgot Password?

or

Continue with Facebook

Continue with Google
Sign Up

Full Name

Email address

Confirm Email Address

Password

or

Continue with Facebook

Continue with Google

Chapter 6

Nuances of Investing in Frontier Equity Markets

R. McFall Lamm, Jr. Stelac Advisory Services LLC, New York, NY, United States

Abstract

On the surface, frontier markets appear to offer extraordinary potential for investors that is reminiscent of past booms in emerging markets when market liberalization and improved macroeconomic governance stimulated economic growth and produced great equity returns. But frontier markets today represent different challenges from that bygone era. Many frontier markets are small and lack liquidity. Others are fallen angels formerly classified as emerging markets, illustrating that past growth does not always predict performance. Taking these and other considerations into account, we review the current state of the frontier markets world and describe where investment opportunities are likely to be in the future.

Keywords

frontier markets

equity performance

growth–return correlation

portfolio diversification

The attraction of frontier markets today rests to a considerable extent on the legacy of emerging markets where surging economic growth in past decades produced extraordinary equity gains. Although casual observers see only an 11.6% annual return for emerging markets versus 10.6% for the S&P 500 over the past 26 years, virtually all the emerging market outperformance came in two great waves. The first was from 1988 to 1993 with the takeoff of the Asian tiger cubs and as Latin American economies beat back crippling inflation. The second nexus lasted from 2003 to 2007 with the advent of the BRICs (Brazil, Russia, India, and China). In both periods, emerging market equities outperformed the S&P 500 by 100%.

Strong growth was not the cause of these booms but the result of deliberate actions that spurred it. The true catalysts included: (1) improved fiscal management and increased central bank effectiveness that stabilized previously volatile economies; (2) the unleashing of market forces with the privatization of state-owned enterprises and elimination of excessive regulatory burdens, which greatly boosted capital market efficiency; and (3) other structural changes such as dismantling trade barriers and allowing foreign ownership of assets that stimulated investment inflows.

Market liberalization measures almost always yield immediate and large benefits. Nonetheless, the impact fades with time after the initial adjustment to the new equilibrium. That’s why investing in emerging markets is now a much more challenging endeavor—the easy steps required to unlock dormant potential are long done, and it’s down to the nuts and bolts of working hard to compete in a vibrant global economy.

With emerging markets seemingly “played out” in the aftermath of breakout transformations—as witnessed by a half decade of equity market underperformance versus developed markets such as the United States—some snake-oil peddlers are touting the beginning of a new dawn for frontier markets where supposedly lucrative payoffs await anyone willing to commit. The sales pitch cliché is that frontier markets are growing very fast and this alone will produce a magical replication of the emerging markets phenomenon in the wunderkind years. This confuses cause and effect since the relevant question is whether there is room in frontier markets for additional reform measures to continue fueling rapid expansion.

Frontier markets are not analogous to the emerging markets of old, with the most obvious distinction being that any frontier market that meets basic investing standards today is already included in the major emerging market indices. Some frontier markets are continuing to liberalize and therefore have excellent growth prospects. These countries will soon be upgraded to emerging market status. However, many frontier markets are extremely small and will remain microcaps forever, lacking the critical mass to absorb substantial global capital markets inflows. Then there are the “fallen angels”—countries previously classified as emerging markets but demoted after retrogressing. In essence, frontier markets are an eclectic mix of hopefuls awaiting promotion to the big leagues, microcaps with uncertain outlooks, and truants in need of remediation. There is opportunity for investors—especially for those who approach portfolio management from a macro perspective—but it is more diffused than the original emerging markets story.

The next section of this chapter discusses the frontier market world as it exists at present. We then review reported frontier market index returns, highlight methodological deficiencies, and suggest a framework for evaluating future opportunity. The subsequent section considers the advantages of investing in individual frontier markets versus “buying the basket.” We conclude that the available liquidity pool dictates investment possibilities, and the ultimate results attained will depend on one’s individual skill in country selection.

1. The Frontier Market Paradigm

As already noted, an acceleration in the pace of economic expansion is usually a consequence of market-friendly restructuring with state-owned enterprises being privatized, capital markets opened to outsiders, and macrogovernance significantly improved. Such conditions normally induce growth and robust equity returns, and in this way frontier markets are reminiscent of emerging markets in times past. For those anxious for investment opportunity, the first impulse might be to jump in quickly.

However, the scope for further market liberalization and advancement is mixed. Numerous frontier countries retain undue restrictions on market access, have capital controls, and suffer from chronically depreciating currencies due to macroeconomic malfeasance. Others lack corporate reporting transparency and creditable accounting standards, and liquidity is limited on local exchanges. Some governments in frontier countries are progressively striving to make needed adjustments. But elsewhere, indifference prevails, with leaders focused on appeasing vested interests and redistributing income to friends and family.

The lists of frontier markets included in the major indices published by Morgan Stanley Capital International (MSCI), Standard & Poor’s (S&P), and the Financial Times Stock Exchange (FTSE) reflect the dissonance—there is a wide range of populations, income levels, and free-market proclivities. They can be split into the following rudimentary categories.

1.1. Rising Stars

This cluster includes countries that fit the traditional notion of a budding emerging market, except they are not quite there yet. Vietnam is perhaps the best example—it has a fairly large population and is experiencing strong growth in response to a concerted effort by the government to free up the private sector and encourage outside investment by reducing foreign ownership limits on stocks and property. Officials have a stated goal of qualifying for inclusion in emerging market indices in hopes of motivating increased foreign direct investment.

1.2. Microcaps

The second and largest group in the frontier markets domain consists of countries that are quite small. They may never qualify as emerging markets because, even with high growth rates, their market capitalizations will never rise sufficiently to make them anything more than rounding errors in a global investing context. This is for no fault of their own; it’s just reality—diminutive markets simply cannot absorb even a small portion of the enormous amount of global capital looking for a home. The roster includes the minor Baltic and Balkan states in Europe, various Central American and Caribbean nations, and island-states scattered around the planet. While a few companies in these markets may grow to be regional competitors, having one or two larger firms does not suffice.

1.3. Fallen Angels

A large share of frontier market capitalization consists of fallen angels. These countries were once in the major emerging market indices but failed to maintain standards and were expelled. For example, MSCI jettisoned Venezuela from its emerging markets index in 2006, Pakistan and Jordan were booted out in 2008, Bangladesh and Argentina were excluded in 2009, and Morocco was dropped in 2013. With the exception of Venezuela—where the government has abrogated basic property rights and rendered the currency inconvertible—all now reside in frontier land.

Further delineations could be made. Many African states have large populations and in a decade or so may evolve to the point where they have vibrant corporate sectors and readily accessible stock markets. But for the moment, it is naïve to expect free market revolutions to produce explosive equity market performance when education, health care, and combating terrorism are imminent priorities. Another subclass of frontier markets could be commodity-dependent economies such as Kuwait, Nigeria, Bahrain, and Kazakhstan whose fates are linked directly or indirectly to energy exposure.

A few countries with large equity markets do not appear on either the frontier or the emerging market registries. Saudi Arabia is rich and has a large stock market. Unfortunately, foreign stock ownership is restricted—a situation that is changing. Index compilers say the nation will soon be categorized as an emerging market, but with no stopover as a frontier market. China A-shares are also excluded from major international benchmarks due to a complex quota system placed on foreign ownership. Like Saudi Arabia, the system is loosening up and most index providers have affirmed that they will add A-shares by 2017; however, this was before the bubble crash in the early summer of 2015 when the Chinese government banned initial public offerings (IPOs), suspended trading in more than a thousand listed companies, and prohibited executives and large shareholders from selling.

2. Frontier Market Performance

Given this backdrop of conceptual amorphousness, it is difficult to generalize, and the phrase “frontier market performance” is really a euphemism since the included markets are so diverse. Nonetheless, the index providers all publish historical returns for frontier markets, notwithstanding the absence of clarity or the fact that returns cannot be replicated by investors. Index interpretation is also rendered difficult by the use of weighting schemes that exhibit extreme shifts when countries are added or subtracted.

An example of the weighting problem is MSCI’s realignment of its frontier markets index in mid-2014 when the United Arab Emirates (UAE) and Qatar were promoted to the emerging markets category. Before the revamp, oil-rich economies dominated, with the UAE, Qatar, Kuwait, and Nigeria representing almost 75% of the total. After the changeover, Kuwait and Nigeria remained but more than 25% of capitalization had vanished overnight and the index morphed from being a concentrated Gulf State and energy-centric construction to having a much larger African and Asian focus with significantly lower petroleum exposure.^a Such an extreme makeover renders the veracity of historical returns questionable.

It’s not just abrupt index realignments that are problematic, but capitalization-based weighting schemes bias the outcome. Table 6.1 summarizes the regional distribution of the major frontier market indices and shows country concentration ratios. All the indices have disproportionately large weights on a relatively few markets, with the top four accounting for nearly half the total in every instance. Conversely, the smallest 10 countries represent no more than a minuscule 7% of any index. While this is a natural consequence of capitalization weighting, the results are highly skewed.

Table 6.1

Frontier Market Index Comparisons—Country Weight Distribution

Region/country	Frontier markets				Emerging markets (MSCI)
Region/country	Old MSCI	New MSCI	S&P	FTSE	Emerging markets (MSCI)
Number of countries	25	24	34	22	23
Weight by region
Middle East	57.3%	32.4%	26.9%	33.2%	1.6%
Africa	19.7%	29.5%	19.9%	26.5%	8.0%
Europe	5.7%	8.2%	10.4%	6.5%	8.4%
Asia	14.4%	21.9%	25.7%	20.5%	65.2%
Latin/Caribbean	2.9%	8.0%	17.1%	13.3%	16.8%
	100.0%	100.0%	100.0%	100.0%	100.0%
Energy exporters	73.0%	49.1%	25.3%	44.1%	7.0%
Largest 4 countries	66.0%	55.6%	45.4%	65.6%	57.0%
Largest 2 countries	38.8%	39.6%	26.9%	43.8%	35.5%
Smallest 10 countries	4.8%	6.7%	4.2%	4.0%	6.8%

Source: Company data from websites as of first quarter 2015.

There are also disparities in which countries are considered frontier markets. S&P includes 34 countries in its frontier index whereas FTSE and MSCI include 22 and 24 markets, respectively. This makes regional allocations different. FTSE and MSCI have significantly greater allocations to Africa whereas the S&P frontier index has a much larger weight on Latin America and the Caribbean region. There is no universal consensus.

Index limitations have not prevented researchers from taking aggregate frontier market returns at face value. For example, Miles (2005), Spiedell and Krohne (2007), Quisenberry and Griffith (2010), and Berger et al. (2013) all examine frontier market performance using reported returns. Others at least focus on frontier regions, with Bley and Saad (2012) considering the Gulf, and Kiviaho et al. (2014) examining behavior in European frontier markets. Berger et al. (2011) evaluate country returns to build proxy aggregates.

More worrying are product providers that enthusiastically promote the merits of frontier investing using unadulterated index return history—or at least they did until the past year when frontier market returns fell significantly and performance decay softened the accolades. Fig. 6.1 compares MSCI frontier market returns, which we take from Bloomberg, versus emerging markets and the S&P 500. The MSCI index begins in 2002, and the data show that frontier markets delivered attractive returns until 2008 when the market crashed sharply during the financial crisis. Recovery followed with a sharp advance, especially in 2013 through mid-2014. However, we are still not back to the prior peak—a somewhat shocking revelation for frontier market advocates who continue to extrapolate past rapid growth and higher returns into perpetuity.

Figure 6.1 Frontier market returns. (Source: From Bloomberg.)

What’s also interesting is that reported MSCI frontier market returns are 9.7% versus 11.7% annually for emerging markets (from index inception in Jul. 2002 through Mar. 2015).^b Frontier markets appear to have underperformed emerging markets. Although the sample is for only 13 years, the result is counterintuitive since one would expect frontier market performance to be at least comparable, particularly if those markets are the new nirvana.

3. Macro Framework

To appraise market performance, one needs a conceptual framework to provide guidance. This is especially the case in frontier markets, where conjecture and speculation on a whim are likely the road to disappointment. Virtually everyone is aware of the simple dividend discount model (DDM) that posits current equity prices as the discounted value of anticipated dividend payments:

$P_{t} = \sum [\frac{D_{t + i}}{(1 + R_{t})}]$ $P_{t} = \sum [\frac{D_{t + i}}{(1 + R_{t})}]$

(6.1)

where P_t is the implied price,

D_{t + i} (i = 1, \dots, I)

$D_{t + i} (i = 1, \dots, I)$

the expected dividend stream, and R_t the discount rate. In the limiting case, if dividends grow perpetually at a constant rate (g), the result is the Gordon discount model or P_t = D_t/(R_t – g).

If the dividend payout ratio (δ) is a constant share of earnings (E_t), and earnings growth is proportionate to the rate of economic expansion [g = φy with y equaling steady-state gross domestic product (GDP) growth], then:

$P_{t} = δ \frac{E_{t}}{(R_{t} - φ y)}$ $P_{t} = δ \frac{E_{t}}{(R_{t} - φ y)}$

(6.2)

Rapidly growing markets should have higher prices versus low-growth rivals, and an increase in the pace of long-term economic expansion should produce a proportionately faster rise in stock prices. Researchers such as Lamm (2015) have confirmed that this positive return–growth relationship generally holds for both developed and emerging markets over long horizons. There is empirical truth in asserting that rapid growth is conjoint with greater equity returns.

The trouble is that in frontier markets, dividend growth is likely to be erratic, payout ratios fluctuate, and the profit share of GDP can shift dramatically as a function of macro decisions. Accordingly, most analysts prefer more refined models. One is the equity return arbitrage relationship, which states that equity returns depend on expectations, a stochastic equity risk premium, and expected real interest rates. Redefining E_t as the current period expectation, this model can be written as:

$r_{t} = b_{0} + b_{1} E_{t}^{+} r_{t + 1} - b_{2} (R_{t} - E_{t} ∆ p_{t + 1}) + ɛ_{t}$ $r_{t} = b_{0} + b_{1} E_{t}^{+} r_{t + 1} - b_{2} (R_{t} - E_{t} ∆ p_{t + 1}) + ɛ_{t}$

(6.3)

where r_t is the log real total return index, R_t is the interest rate,

E_{t}^{+} r_{t + 1}

$E_{t}^{+} r_{t + 1}$

is the expected next period return index, and E_t∆p_t+1 is expected inflation. The equity risk premium is embedded in the intercept and the stochastic residual with the expectations operator E⁺ denoting expectations by financial market participants based on a broader information set compared with other agents in the economy.^c Expectations are not observable but often postulated as a combination of anticipated economic and earnings growth rates, currency values, tax rates, and valuation metrics such as price-to-earnings ratios and dividend yields.

The difference from the simple DDM is the emphasis on expected real rates and the admission of other factors that influence expected returns. This allows for the tangible possibility that higher-growth countries may deliver poor returns if other macro influences negatively offset, or if the future turns out to be less rosy than expected. That’s why fallen angels dwell in the frontier equity market universe—it is not preordained that market liberalization will persist and thereby spark strong economic expansion with superior equity performance, especially if overly exuberant expectations are already embedded in the price.

A major reason to highlight return-prediction models is to illustrate the distinction between investing in one country versus buying a basket. Basket returns—usually based on the most widely accepted index—are dependent on the weights assigned to each market. The total expected portfolio return from investing in a group of J frontier markets is:

$E_{t}^{+} r_{t + 1}^{p} = {[\begin{array}{c} w_{1} \\ w_{2} \\ ⋮ \end{array}]}^{T} [\begin{array}{c} r_{1 t} \\ r_{2 t} \\ ⋮ \end{array}] = {[\begin{array}{c} w_{1} \\ w_{2} \\ ⋮ \end{array}]}^{T} [\begin{array}{c} b_{10} + b_{11} E_{t}^{+} r_{1, t + 1} - b_{12} (R_{1 t} - E_{t} ∆ p_{1, t + 1}) \\ b_{20} + b_{21} E_{t}^{+} r_{2, t + 1} - b_{22} (R_{2 t} - E_{t} ∆ p_{2, t + 1}) \\ ⋮ \end{array}]$ $E_{t}^{+} r_{t + 1}^{p} = {[\begin{array}{c} w_{1} \\ w_{2} \\ ⋮ \end{array}]}^{T} [\begin{array}{c} r_{1 t} \\ r_{2 t} \\ ⋮ \end{array}] = {[\begin{array}{c} w_{1} \\ w_{2} \\ ⋮ \end{array}]}^{T} [\begin{array}{c} b_{10} + b_{11} E_{t}^{+} r_{1, t + 1} - b_{12} (R_{1 t} - E_{t} ∆ p_{1, t + 1}) \\ b_{20} + b_{21} E_{t}^{+} r_{2, t + 1} - b_{22} (R_{2 t} - E_{t} ∆ p_{2, t + 1}) \\ ⋮ \end{array}]$

(6.4)

where w_j is the country weight with ∑w_j = 1. This expression illustrates that, first, forecasting returns for frontier markets in aggregate is a complex task depending on a weighted sum of individual country predictions and, second, the weighting system is a critical component of portfolio returns.

In this regard, undue concentration in a few larger countries can heavily influence aggregate returns. Smart investors who correctly predict the frontier markets that outperform may nonetheless post subpar performance if they buy a basket that overweights the wrong markets. Buying the basket arbitrarily mutes return possibilities for someone who has good country forecasting models.

4. A Better Measure of Frontier Market Returns

In the situation where one has no view on expected returns, the standard market capitalization weighting method employed by indexers necessarily implies that, in a mean-variance optimization context, higher returns are expected for countries with the largest stock markets since they have the biggest weights. However, size does not predict performance, and in this respect equal weighting is more appropriate than capitalization weighting since there is no judgment made about prospective returns.^d Equal weighting provides a neutral benchmark, which is germane for frontier markets since it eliminates the overconcentration problem and mitigates the influence of erratic weight changes.

This argument was made by Lamm (2011), who showed that weighting emerging markets equally produces significantly higher returns than weighting them by capitalization, suggesting that equal weights diversify country risk more effectively. Equal weighting need not necessarily lead to higher overall portfolio returns, though, since it is possible that cap weighting can deliver better results if the overweighted countries outperform.

To calculate an equally weighted generic benchmark for frontier markets, I take the countries included in the MSCI Frontier Index and simply average past historical monthly returns. The results are shown in Table 6.2, which provides comparisons with returns for the actual MSCI frontier and emerging markets indices, and their equal-weight equivalents, as well as the S&P 500. Equally weighted frontier market returns are 13.0% versus 14.3% for emerging markets over 154 months from Jun. 2002 through the first quarter of 2015—substantially higher than their cap-weighted equivalents.^e In addition, the frontier market performance gap versus emerging markets narrows and volatility falls by 2.0%, producing a higher return-to-risk ratio. This is more consistent with what one would expect—frontier market returns appear more favorable versus emerging markets than when cap weighting is used.

Table 6.2

Frontier Market Returns and Performance Metrics

Measure	Cap-weighted		Equal weights		S&P 500
Measure	Frontier	EM	Frontier	EM	S&P 500
Months	154	154	154	154	154
Return (annualized)	9.5%	11.0%	13.0%	14.3%	7.4%
Volatility (annualized)	19.4%	22.6%	17.4%	22.2%	14.8%
Return-to-risk ratio	0.49	0.49	0.75	0.64	0.50
Skew	−0.67	−0.64	−1.36	−0.79	−0.78
Correlation
Frontier cap-weighted	1.00	0.59	0.80	0.66	0.54
EM cap-weighted		1.00	0.74	0.97	0.79
Frontier equal-weighted			1.00	0.80	0.64
EM equal-weighted				1.00	0.79

Source: Author’s calculations off MSCI monthly data from Jun. 2002 to Mar. 2015.

Also interesting is that equal weighting mutes the apparent diversification advantage of frontier markets. For example, returns for the mainstream cap-weighted MSCI Frontier Index have correlations of 0.59 and 0.54 with emerging markets and the S&P 500, respectively. The same correlations for the equally weighted frontier index are 0.80 and 0.64. Proponents have long argued that a key advantage of frontier markets is low correlation with other global equity markets. Equal weighting suggests that it is less than it appears due to overconcentration in the cap-weighting scheme. The case may be that frontier markets are already more integrated with the global equity market than commonly perceived, with a portion of the portfolio diversification benefits having already been arbitraged away.

5. Individual Countries Versus Baskets

According to Campbell and Thompson (2008) and many others, equity returns are predictable (in part) using return-generating models similar to that of Eq. 6.3. Therefore, if you possess macro models capable of predicting frontier market returns, then the obvious route is to build a portfolio consisting of the expected stars. For sure, the forecasting challenges in country selection are nontrivial and a lot of toil is required to assess crossmarket prospects for growth, real interest rates, inflation, and other factors covering dozens of countries. It is easy to make mistakes.

As an illustration, a sharp surge in inflation from, say, 5% to 10% for any country can have a devastating impact on equity returns by driving up interest rates and depressing currency values. Governments can also unexpectedly change policies for the worse; new taxes, subsidies, fees, capital controls, increased deficit spending, excessive debt issuance, deleterious monetary policy, privatization reversals, and other actions can morph a favorable macro environment into perdition (Venezuela and Argentina come to mind). The scale of the country selection challenge is reflected in Table 6.3, which shows that frontier markets offer enormous variation in population, per capita GDP, unemployment rates, inflation, and market size.

Table 6.3

Country Weights in Various Frontier Market Indices and Comparative Economic Metrics

Country	MSCI (%)	S&P (%)	FTSE (%)	Population (mil)	GDP/capita ($000)	Unemployment (%)	Inflation (%)	Market cap ($bil)
Argentina	8.0	12.0	13.3	43.0	11.6	7.1	22.1	63
Bahrain	1.2	2.9	0.3	1.3	43.8	4.1	2.5	16
Bangladesh	2.5	3.7	8.4	166.3	2.9	—	7.0	—
Botswana	—	0.8	0.6	2.1	15.8	—	—	5
Bulgaria	0.2	0.3	0.2	6.9	15.7	10.1	−0.2	4
Croatia	1.7	1.6	0.8	4.5	21.3	17.1	0.3	19
Cyprus	—	0.2	0.1	1.2	28.2	15.6	−0.1	4
Ecuador	—	0.7	—	15.6	—	4.8	4.2	—
Estonia	0.4	0.3	0.5	1.3	25.8	4.3	0.4	2
Ghana	—	0.6	0.1	30.5	3.9	—	14.8	3
Jordan	0.7	3.6	1.1	7.6	11.8	—	1.3	25
Kazakhstan	3.6	3.1	—	19.0	23.2	5.3	8.2	12
Kenya	6.0	4.4	7.0	45.0	2.8	—	6.7	23
Kuwait	23.4	18.5	—	4.7	83.8	—	1.8	89
Lithuania	0.1	0.2	0.1	3.5	25.4	10.0	−0.2	4
Mauritius	1.3	1.9	1.5	1.2	17.7	—	—	10
Morocco	6.6	—	—	33.0	7.2	9.9	4.6	50
Nigeria	16.2	12.3	17.7	177.2	5.6	10.0	9.6	56
Oman	4.7	3.5	5.7	4.9	44.0	—	1.0	25
Qatar	—	—	26.1	2.8	136.7	—	2.5	177
Pakistan	8.0	6.7	—	196.2	4.6	6.2	4.4	75
Panama	—	3.8	—	4.4	19.4	—	—	—
Romania	2.7	2.0	2.8	19.3	20.0	6.6	0.7	19
Serbia	0.2	—	0.3	7.1	—	20.6	2.9	—
Slovenia	2.6	1.8	1.7	2.0	—	12.5	−0.2	7
Sri Lanka	2.3	2.7	2.7	21.8	9.7	—	1.9	21
Tunisia	0.7	0.8	1.2	10.9	11.1	—	4.6	10
Ukraine	0.2	—	—	44.3	8.8	9.5	30.2	5
Venezuela	—	—	—	33.4	18.2	8.1	85.4	260
Vietnam	4.2	3.5	7.8	93.4	5.3	5.8	2.0	59

Market weights are from company websites at the end of the first quarter 2015. Other data are from Bloomberg, either the latest available or 2015 forecast with GDP per capita in constant USD.

There are also nuances to be considered in country selection where even the relationship between growth and returns has to be carefully evaluated. This is illustrated in Fig. 6.2, which shows the correlation between economic growth and equity returns for 17 frontier markets.^f The contemporaneous growth–return correlations are reported as well as the correlation between this year’s return and next year’s projected growth. It is this latter measure that is pertinent—equity markets price in next year’s growth today, and this is why the correlation between current returns and t + 1 growth averages a statistically significant 0.60 versus negligible correlation between current returns and growth.

Figure 6.2 Return–growth correlations for selected frontier markets.

That country selection offers real opportunity for frontier markets is also supported by low crossmarket equity return correlations. It is beyond the scope of this chapter to review results from our entire analysis—we have 100 months of common history for 21 frontier markets and 23 emerging markets, or 463 crosscorrelation values. However, the average correlation across frontier markets is only 0.34, with Pakistan and Vietnam having the lowest values at 0.20 and 0.23, respectively. For emerging markets the average cross-country correlation 0.58. This compares with a correlation between US and European equity returns of 0.90 over the same period.^g

The alternative to country selection is to simply buy the basket. Such a strategy might prove successful vis-a-vis investing in emerging markets if macro reforms turn out to be more favorable. Of course, any growth premium might already be incorporated into prices, and, as already emphasized, basket returns are subject to vicarious changes in index weights—something avoidable by investing in specific countries since if a country is removed from the index, you still own the exposure.

There is another reason to be cautious:frontier markets collectively are starting from a better position than emerging markets in their heyday. For example, Lamm (2010) notes that “as late as 1993, more than a dozen of the MSCI emerging countries still reported double-digit inflation.” Only four of the 30 frontier countries listed in Table 6.3 are posting double-digit inflation at the moment (and one is Venezuela, which is not in any index). The straightforward and very large benefits from eradicating high inflation and bringing real interest rates down are no longer available.

Less room for macro progress combined with the importance of expectations in determining returns makes it difficult to argue with blind faith that frontier markets will outperform emerging markets going forward. That said, frontier markets now appear more favorably priced than usual versus emerging markets, with price-to-earnings ratios at 11.0 versus 14.0 and dividend yields of 3.8% compared with 2.6%.

Our opinion is that one needs to make the concerted effort necessary to identify outperformers via country selection because the opportunity space is much larger than the binary “take it or leave it” option of buying the basket. Consider that over the past 5 years frontier market returns have ranged from highs of 19.6 and 15.3% per year for Kenya and Pakistan to lows of −28.2 and −14.2% for Ukraine and Bahrain. Even a little tilt in the right direction can make a huge difference. Country allocation is consistent with Samuelson's (1974) dictum, which asserts that markets are micro efficient and macro inefficient.^h Though buying a frontier basket can be viewed as exploiting macro inefficiency, having dozens of frontier countries from which to choose tremendously enhances the chance for greater reward.

6. Liquidity Pools

Unfortunately, the country selection opportunity in frontier markets is severely constrained by available market liquidity; suitable investment vehicles are widely lacking. Indeed, there is abundant market depth for only one frontier market—Vietnam—where Market Vectors offers an exchange-traded fund (ETF) with nearly a half billion dollars in market capitalization and a trading history of more than 5 years. Market Vectors also has an Africa ETF, and WisdomTree offers a Middle East ETF, with $91 and 32 million in market capitalization, respectively, but these are regional baskets.

The most innovative frontier market provider is Global X, which has stand-alone ETFs for Argentina, Nigeria, and Pakistan. However, at this juncture the ETFs have only $17, 15, 5, and 3 million each in market capitalization, which is not a lot. Hopefully, these amounts will increase, as these ETFs are fairly young in their life cycles and the need for deeper markets is strong.

The limited availability of investment instruments for individual frontier markets contrasts markedly with the situation for emerging markets, where liquid ETFs exist for practically every country. This points to yet another distinction between frontier and emerging markets: one can readily apply a country selection strategy for emerging markets. In view of our premise that the drivers of frontier market behavior are not radically dissimilar from those for emerging markets, investors with sophisticated macro forecasting skills are well advised simply to supplement their country selection menu with the liquid frontier market names to broaden the platform.

As for buying the basket—a decidedly less preferable course of action since one must surrender the country selection decision—liquidity is substantially greater, with several billion dollars in assets under management in a variety of formats. There is the iShares MSCI Frontier 100 ETF, which is designed to track the largest companies included in the MSCI Frontier Index. The market capitalization is near $600 million. But you are stuck with 26% of your investment in Kuwait, 14% in Argentina, 13% in Nigeria, and 10% in Pakistan with banks representing 43% of the exposure (as of this writing). With almost two-thirds of the total dedicated to four countries, you need to be bullish on these markets and enamored with financial institutions to justify the wager.

One other ETF that addresses the broad market is Guggenheim’s Frontier Market Index ETF (FRN), which has $59 million in market capitalization and tracks something called the “Bank of New York Mellon New Frontier Depositary Receipt Index,” which includes underlying companies whose shares trade in the United States and United Kingdom. Building an index of shares conveniently bought and sold on major markets is in the provider’s interest and represents biased selection. Proceed with caution, as one always should if a product’s name contains more than a half dozen words.

As Fig. 6.3 indicates, there is even more liquidity in actively managed US open-end funds dedicated to frontier investing, and some have performed quite well. Nonetheless, any commitment means that you are buying an unknown country allocation and must rely on the portfolio manager. Templeton and Morgan Stanley have the largest presences and best-known funds in this group. There are other funds that invest in both frontier and emerging markets (which is also true for some ETFs). We exclude them from consideration since the weighting problem is hugely compounded.

Figure 6.3 Market capitalization of various frontier market investment vehicles. (Source: From Bloomberg.)

The number of options is greater offshore, where in London, Luxembourg, Dublin, and other markets there are more specialized vehicles dedicated to specific countries and regions, including Pakistan, Vietnam, Nigeria, the Middle East, Africa, central Asia, the Baltics, and the Balkans. Many of the investment vehicles are closed-end funds with limited liquidity, and virtually all trade at steep discounts to net asset value. Some investors view discounts as bargains, but discounts can persist for years and may be entirely rational to amortize the large fees often charged (most US investors venturing offshore are often shocked by huge expense ratios and the lack of transparency vs at home). Most offshore funds are small, less competitive, and cater to unsophisticated investors—and with high fees they should generally be avoided.

One additional avenue for the really adventurous is to seek out local managers in the country or region of interest. For example, there is a large array of country funds offered in Pakistan. There are also Baltic funds domiciled in the Baltic countries, Balkan funds available in the Balkans, and Nigerian funds traded in Lagos. Significant due diligence is required, and you are ultimately exposed to an additional layer of risk: frontier market regulation applies (or the lack thereof), and you are forced to rely on a different legal system in the event the fund manager vanishes with your money.

Hedge funds dedicated to investing in specific frontier regions offer an added venue. However, the same comments apply: you are dependent on the manager’s choice of countries, and performance can vary drastically (and even directionally) from standard benchmarks. The added bonus in the case of hedge funds is that you qualify to pay 2/20% for the privilege of surrendering your money. That leaves you with 100% of the downside and only 78% of the upside—a negatively skewed payoff profile which is usually a very bad business proposition.ⁱ

Even so, while I would normally contend that active managers should be avoided like the plague due to excessive fees that only subtract from returns, frontier markets are a special case and paying for access may make sense. Active managers help fill the void of nonexistent liquidity and, if you can identify a good manager and are sufficiently bullish on the frontier market basket to the point that expected returns will offset the added costs, then by all means forge ahead.

One precaution is to avoid active managers who espouse stock-picking prowess over country-selection skill (an approach especially favored by UK-based managers), as any value added is much more likely to come from being in the right markets. Another caveat is to carefully preview the manager’s country allocation. At least one active fund manager we know has outperformed the frontier market indices by slipping in substantial exposure to countries normally classified as emerging markets. While this is legitimate within the written investment mandate, such style drift may not be what is desired.

7. Conclusions

With promotional books in print and pundits championing their appeal, frontier market investing has become fashionable in spite of its small size relative to global equity markets. New exciting and exotic investment opportunities await discovery that will produce extraordinary returns—or so proponents claim. Their weak proof is that less prosperous countries will grow faster than others in the future—a boorish truism that has largely existed since the beginning of time. When you explore the subject in depth, you discover that reality is not so simple and fast growth at the moment does not assure the same tomorrow.

The situation in frontier markets is somewhat muddied by index builders that publish returns based on a weird concoction of countries including the big and small, the free-market-oriented versus state-controlled, the rich and poor, and rapidly growing versus those that have sunk into the abyss. To suggest that such an eclectic mix has a high probability of collectively outperforming other investible markets is disingenuous, and to report historical returns that are based on a changing mix of countries with erratic weight fluctuations is misleading. It is no slam dunk that buying an ill-defined frontier market basket will pay off.

We prefer country selection as the best recourse as opposed to being forced to buy the good, the bad, and the ugly all at once. The obvious issue is liquidity, which is generally nascent. Even so, it is increasing—6 years ago there were no individual country frontier market ETFs, and now there are five with market capitalization slowly rising. It may be just that a little more time is required for a more complete set of choices to present itself. Such was the case for emerging markets, where smaller markets such as the Philippines, Chile, Colombia, and Poland took several years to build ETF critical mass.

..................Content has been hidden....................

You can't read the all page of ebook, please click here login for view all page.

Table of Contents for Chapter 6: Nuances of Investing in Frontier Equity Markets

Create new playlist

Sign In

Sign Up