Finding fast-growing companies around the world is the aim of many investors, with the more intrepid prepared to explore new frontiers to achieve this goal.
Frontier markets are countries with stock markets which are, often small and illiquid, and are not yet considered emerging markets. They may sometimes be known as ‘pre-emerging markets’ and are generally more volatile than more established stock markets. They may be subject to greater social or political instability and are typically less well regulated than other markets.
MSCI (Morgan Stanley Capital International), which measures stock market performance in a range of different areas, classifies 33 countries, including Argentina, Bahrain, Bangladesh, Kenya, Morocco, Oman and Vietnam, as frontier markets and 29 of these are included in the MSCI Frontier Markets Index. The index is made up of 116 companies, with the Kuwait-based bank the National Bank of Kuwait, and Vietnam Dairy Products, the largest dairy company in Vietnam, among the top 10.
Although MSCI categorises these countries specifically as frontier, elsewhere they may fall into the emerging markets category. For example, funds in The Investment Association’s Global Emerging Markets sector may provide exposure to frontier markets. The Investment Association is the trade body that represents UK investment managers. According to the Association, the maximum frontier equity exposure for funds in the Global Emerging Markets sector is restricted to 20% of the total fund. Funds which invest solely in frontier markets are included in the Specialist sector.
Typical characteristics of frontier markets
Frontier economies are often rich in natural resources. For example, the continent of Africa has nearly two-thirds of the world’s mineral reserves, and more than half of the world’s mineral reserves for gold, platinum group metals, cobalt and diamonds. It also has among the largest reserves of uranium, manganese and chromium.
Many frontier countries also have large and relatively young populations, and a higher ratio of workers to those who are retired. For example, in Nigeria, Kenya and Bangladesh, 44%, 42% and 30% of people respectively are under the age of 15, compared to just 13% in both Japan and Germany.
However, although they may have sizeable young populations which can lead to a bigger workforce, frontier countries often have an immature financial infrastructure. Companies in frontier markets may have poor levels of shareholder and corporate governance, and there is often a lack of information available to investors.
The risks of investing in frontier markets are therefore much greater than investing in more developed emerging markets such as China, Brazil and India. Investments in these areas should therefore only be considered by investors with a very strong appetite for risk - and even then should only make up a small part of any portfolio.
Outlook for frontier markets
For investors with a very strong appetite for risk and who accept there is a high chance they could lose some or all their investment, prospects in many frontier markets are improving. For example, Nigeria, finally emerged from recession in the second quarter of this year, having previously been hit by falling oil revenues. Increased infrastructure spending was announced in the 2017 budget to help fund projects such as another runway for the capital Abuja’s airport and the $5.8 billion Mambilla hydropower dam.
Argentina is also showing positive signs, with both its gross domestic product and currency strengthening as inflation has plummeted. Former Buenos Aires Mayor Mauricio Macri, elected president two years ago, has ended trade, price and currency controls and the country is poised to become the fifth-best economy in the Group of 20 nations, an international forum which brings together the world’s 20 leading industrialised and emerging economies. Last summer, however, Argentine equities in the US fell after the MSCI declined to upgrade Mexico to emerging market status.
The outlook is less positive in other frontier markets. For example, many of those in the Middle East depend heavily on oil, although oil is not considered the energy of the future, with renewable energy resources the fastest growing sector of the energy market.
Meanwhile, political tensions in other frontier markets have the potential to moderate economic growth prospects. Kenya, for example, has seen significant political instability in recent months, after the Supreme Court ordered a re-run election following President Uhuru Kenyatta’s re-election.The IMF has lowered its 2017 economic growth forecast for Kenya to 5% following a drought which saw farming output contract and pushed up food prices.
Ways to gain exposure
Despite the risks involved, for the reasons outlined above, frontier markets tend to have little correlation either with developed markets or emerging markets. This can make them a possible portfolio diversifier, although they definitely aren’t for the faint-hearted.
It’s vital for investors to remember that even though many frontier markets have seen improvements in recent years, they often remain rife with political and economic risk. There’s no guarantee, for example, that improvements in governance will continue, or that political risks will subside. Bear in mind too that overseas investments will be affected by currency exchange rate fluctuations. If sterling strengthens, your returns from overseas investments will fall. Conversely, if sterling weakens, your returns from overseas investments will increase.
One way to gain exposure to frontier markets is through a fund that has a global approach, with small holdings in different markets around the world. For example, the Templeton Frontier Market fund (LU0768359852) invests mainly in equity securities issued by companies of any size located in, or doing significant business in, frontier markets. Its current biggest holdings include DHG Pharmaceutical, a pharmaceutical manufacturer in Vietnam, and the National Bank of Kuwait.
This fund was closed for new investment for four years until May 2017, to manage flows into its portfolios. Responsible managers may ‘soft close’ their funds when they feel they are starting to get too large, and will reopen them when they feel they can take on more assets. Managers of funds investing in frontier markets also have to contend with the fact that when market conditions are difficult, the fund may not be able to sell a security for full value or at all, which could cause the fund to defer or suspend redemptions of its shares i.e. investors will not be able to sell their shares.
Other investments which offer exposure to frontier markets include the iShares MSCI Frontier Exchange-Traded Fund (ETF) which seeks to track the investment results of the MSCI Frontier Markets 100 Index, and the BlackRock Frontiers investment trust, which aims to achieve long-term capital growth from investment in companies operating in frontier markets, or whose stocks are listed on the stock markets of such countries.
Please note that our referring to these funds does not constitute a recommendation. Also, remember that investments in frontier markets are particularly high risk, so you must be prepared to accept that you may get back much less than you put in, and that you could lose your entire investment. If you’re unsure where to invest, seek professional independent financial advice.