Investing in Frontier Markets: Opportunity, Risk and Role in an Investment Portfolio

By Gavin Graham, Al Emid and David Feather

The only comprehensive guide to reaping big returns investing in the hottest new growth markets

This book makes a compelling case that, just as today's well-rounded portfolio includes emerging market funds, tomorrow's well-rounded portfolio will include frontier market funds. More importantly, it alerts you to the vast opportunities and potential pitfalls of investing in frontier markets while providing expert advice and guidance on how to research and invest in the most promising frontier growth markets. Widely considered to be the next emerging markets, frontier markets, such as those of certain sub-Saharan African, Eastern European, Asian, and Central and South American countries, are showing strong signs of reaching economic critical mass. If you are an investor on the lookout for authoritative, actionable information on the next big investment opportunity, this book is for you.

• Provides sector-by-sector analyses that let you assess opportunities and risks in each frontier market
• Provides strategies and tools for determining the most efficient methods for executing, monitoring, and exiting investments
• Guides you through the wide diversity within frontier markets, showing how to differentiate countries on the basis of economic development and wealth distribution and other factors

• Language: English
• Publisher: Wiley
• Release date: Aug 19, 2013
• ISBN: 9781118556337

Book preview

Chapter 1

Introducing Emerging and Frontier Markets

Over the last decade, returns from developed markets have been effectively zero or negative. In the 10 years ending on December 31, 2012, the Morgan Stanley Capital International Developed World Index returned 5.4 percent annually in U.S. dollars in nominal terms. This extremely disappointing record has been accompanied by enormous volatility, giving investors the worst of both worlds—not only have they effectively not made any money in real terms, but they have experienced moves in the markets that have not been seen since the Great Depression of the 1930s.

Over the same period, emerging markets—defined as those countries with a Gross Domestic Product (GDP) per capita of less than US$12,476 (2012) and which are represented by the MSCI Emerging Markets (Free) Index—have delivered 13.7 percent annually in U.S. dollars, more than doubling an investor's initial investment. There are several reasons for this massive outperformance of more-developed markets by less-developed markets, the most important of which were the low and attractive valuations of the developing as opposed to developed markets at the beginning of the decade. Reasons also include their faster rate of GDP growth, younger populations, higher levels of savings and lower levels of government and personal debt. The growth and success of emerging markets will likely be repeated by the next generation of emerging economies—the frontier markets.

This book examines the factors contributing to the performance of emerging and frontier markets and dispenses practical advice for those considering investing in frontier markets. It defines emerging markets and frontier markets and discusses differences between them, explores the diversity of frontier markets and establishes why it is important to differentiate between regions and between individual countries within regions. Furthermore, it considers the risks inherent in investing in such markets, including poor liquidity and regulation, political instability and inadequate financial reporting, and suggests how to manage these risks. It also explains the importance of distinguishing between the popular image of countries and regions and what is actually happening at ground level.

Investing in Frontier Markets enumerates the key benefits developed market investors can accrue by investing in frontier markets, namely diversification, a low correlation with developed markets and the strong likelihood of frontier markets mirroring the development path followed by longer-established emerging markets, thus delivering strong returns to investors with long-term horizons. The book goes on to examine some of the problems faced by emerging markets during their period of rapid development over the last 15 years. It also looks at the changing role of financial advisors and how they can help position frontier markets in an investor's portfolio and the pitfalls of attempting to go it alone when investing in emerging and frontier markets, for example, by using online investing.

Finally, Investing in Frontier Markets reviews the various routes available for developed market investors to access frontier markets, beginning with exchange-traded funds (ETFs) and continuing with individual stocks, whether global multinational companies with exposure to emerging and frontier markets or American depository receipts (ADRs) or global depository receipts (GDRs) of emerging and frontier listed companies. The book concludes by looking at mutual and closed-end funds invested in frontier markets, including single-country, regional and global closed-end funds and provides recommendations as to the preferred choice for investors.

Emerging Markets

Antoine van Agtmael, an economist at the International Finance Corporation (IFC), the equity arm of the World Bank, first coined the term emerging markets in the early 1980s. The phrase was defined in economic terms: emerging markets were countries with low to middle income per capita. It replaced the earlier description of less-developed countries, which was seen to have pejorative connotations and has become the accepted description of economies that are moving from developing status to developed status.

Each year on July 1, the World Bank divides countries into four categories, based on annual gross national income (GNI) per capita:

low income: below US$1,025

lower-middle income: US$1,026–$4,035

upper-middle income: US$4,036–$12,475

high income: US$12,476 or more¹

The World Bank notes that low income and middle income countries are often referred to as developing economies, but goes on to say that while the term is convenient, it does not imply that all countries in the categories have reached a similar stage of development.²

In effect, emerging markets are low and middle income countries. Another way to define emerging markets is to say that they are those countries that do not belong to the Organisation of Economic Co-operation and Development (OECD), which consists of 34 developed countries. This is not the best definition though, since several of the OECD countries, such as Chile, Estonia, Mexico, South Korea and Turkey, are sometimes included in lists of emerging market economies.

The head of the IFC's emerging market database, Farida Khambata, was the first person to use the term frontier markets, in 1992. Frontier markets are a subset of emerging markets. They are investable but have lower market capitalization and liquidity, or more investment restrictions than the more established emerging markets, or both. These traits make them unsuitable for inclusion in the larger emerging market indices, but nonetheless they display what Marek Ondraschek, Chief Executive Officer of ALNUA Investment Managers, has described as a relative openness to and accessibility for foreign investors while not demonstrating extreme economic and political instability.³

The smaller size and lower liquidity of frontier markets means that they are not particularly correlated with other stock markets around the world, including other emerging markets or each other, thus making them attractive to investors looking for potential high returns while lowering the overall volatility of an investor's portfolio.

Despite the fact that emerging markets have been a recognized asset class for the last quarter century, with Franklin Templeton launching the first closed-end emerging market fund in March 1987⁴ and Morgan Stanley Capital International (MSCI) launching the first comprehensive emerging markets index in 1988, there are still differences of opinion as to which economies should be classified as emerging. The International Monetary Fund (IMF) and providers of stock market indices such as FTSE, MSCI Barra, Standard & Poor's (S&P) and Dow Jones all produce lists that at mid-year 2012 had 24, 22, 21, 19 and 22 countries respectively listed as emerging markets.

The countries that are included in all five lists are as follows:

Asia

China

India

Indonesia

Malaysia

The Philippines

Thailand

Europe, the Middle East and Africa

Hungary

Poland

Russia

South Africa

Turkey

Latin America

Brazil

Chile

Mexico

Peru

This makes 15 countries that five major data providers agree should be classified as emerging markets. Twenty-one countries are included in the emerging market indices compiled by S&P and MSCI, the most widely followed indices, which are as follows:

Asia

China

India

Indonesia

Malaysia

The Philippines

South Korea

Taiwan

Thailand

Europe, the Middle East and Africa

Czech Republic

Egypt

Hungary

Morocco

Poland

Russia

South Africa

Turkey

Latin America

Brazil

Chile

Colombia

Mexico

Peru

Interestingly, several markets, such as Israel and South Korea, which would have been classified as emerging 15 years ago, are no longer included in many lists as they have now emerged. By that, we mean that their GNI per capita has surpassed the top end of the middle-income category. FTSE and MSCI upgraded Israel to the list of developed markets in 2008 and 2010, respectively, and FTSE upgraded South Korea in 2009, as did S&P. In the 30 years or so since the IFC first developed an emerging market index, there have been only two other countries that have been upgraded: Greece and Portugal.

A cutoff point of US$25,000 GDP per capita at market exchange rates includes all of the markets classified as developed, with the exception of Israel, which is in the process of being reclassified. The only developed markets with lower GDP per capita are Portugal (which was promoted in 2001) and South Korea (which is in the process of being reclassified).

Using estimated GDP per capita in 1900 from Angus Maddison's historical database, Elroy Dimson, Paul Marsh and Mike Staunton from the London Business School, authors of Triumph of the Optimists,⁵ ranked developed and emerging markets using the same level of income that corresponds to US$25,000 in 2010. Using this criterion, they note that only seven of the 38 countries with equity markets in 1900 changed status over the following 110 years.

Five markets moved from emerging to developed—Finland, Japan and Hong Kong and, more recently, Portugal and Greece—while Argentina and Chile fell from developed to emerging market status. Adding Singapore, the stock market of which opened in 1911, and the two countries in the process of being reclassified, Israel and South Korea, denotes the eight countries that have emerged over 110 years.⁶

The question of whether developing economies will naturally end up achieving developed country status or whether they will require help and guidance from government and international investors is still a hotly debated topic. Some emerging markets have followed the path of Japan, which after the Meiji Restoration in 1868, used government direction of the economy and financial system to create a modern, industrialized state that could hold its own against the Western colonial powers.

Japan took what it considered to be the most successful examples of best practices from the leading powers, so that it modeled its navy and railways on those of Great Britain and its army and educational system on those of Prussia.

Within 40 years it had defeated one of the major powers, Russia, both on land and sea, and within 80, it had inflicted humiliating reversals on the other major colonial nations of Great Britain, France, the Netherlands and the United States. After military defeat in the Second World War, Japan created an industrial powerhouse that within 30 years was the second largest economy in the world, challenging the United States as the largest industrial power.

The Nikkei-Dow Jones Index, the major Japanese stock market index, appreciated by six times during the 1980s, finishing 1989 at 38,900, making Japan's the most valuable stock market in the world. At the time, it comprised just under 30 percent of the MSCI World Index against 25 percent for the United States. Its 75 percent decline since the Nikkei peaked at the end of December 1989 should not detract from its remarkable success between 1949 and 1989.

Some nations, such as South Korea, a Japanese colony from 1910 to 1945, followed the Japanese path of directed economic development very closely. They specialized in similar industries, initially textiles and toys, then consumer electronics, and most recently steel, telecommunications, automobiles and shipbuilding.

Other countries, including Taiwan, a Japanese colony from 1895 to 1945, chose a different path. With some government direction but also a fair degree of commercial independence, Taiwan specialized in petrochemicals, electronics, telecommunications and computers.

The other members of what were known as the newly industrializing countries (NICs) were existing or former British island colonies: Hong Kong and Singapore. They had no natural resources and larger hostile (or at least ambivalent) neighbors in China, and Indonesia and Malaysia, respectively. Using their positions as major ports and trading hubs, exporting Asian natural resources and low-end manufactured goods in exchange for products from the industrialized nations, they became the wealthiest Asian states ever known, partially due to their inheritance of the rule of law from the British colonial era.

As was constantly stressed by Chris Patten (now Lord Patten of Barnes), the last British governor of Hong Kong (1992–1997), knowing the rules under which commerce would be conducted gives business confidence to invest and grow. Hong Kong offered the closest thing to 19th century laissez-faire capitalism that existed in the 20th century, while Singapore was among the most regulated and organized of countries. However, both succeeded in boosting their GNI per capita more than five times over the last half century.

Interestingly, three of the six countries that have successfully migrated from emerging to developed status over the last 100 years (Japan, Hong Kong and Singapore—four out of eight if we include South Korea and Israel) have been Asian and the remainder European.

None of the NICs were full-fledged democracies during the period of their fastest growth, with South Korea under military rule and Taiwan a one-party state under the Kuomintang Party (KMT), Chiang Kai-shek's nationalist party, until the 1990s. Hong Kong was a British colony until its handover to China in 1997, when it became a Special Administrative Region (SAR) under the one country, two systems agreement. Singapore was effectively a one-party state with the Peoples' Action Party (PAP) winning overwhelming majorities with free elections until this decade. Some observers feel that Japan also could have been classified as a one-party state, as the Liberal Democratic Party (LDP) held power for 40 years, starting in 1955.

Whether non-democratic forms of government are a necessary condition for rapid economic growth is a subject that has been fiercely debated.

The argument for an autocratic government, whether a one-party state, a communist regime or a state ruled by the military, is that an autocracy is able to overcome vested interests that benefit from the existing low-growth economic arrangements. In this view, the owners of property and facilities, with little or no interest in encouraging faster growth, can be considered rent takers, whether literally, in the form of land ownership, or by exacting high fees for the use of resources, in the form of trade guilds or monopolies.

On the other hand, the argument against non-democratic regimes stems from their ability to ignore the rule of law and property rights, which makes it unattractive for investors to risk capital that may end up being confiscated in an arbitrary fashion and without due process.

China, with its one-party status and impressive physical infrastructure but constrained human rights, exemplifies the results of belief in autocratic government. India, with its vibrant democracy, highly educated middle class, rule of law and intellectual infrastructure, but with bottlenecks and capacity constraints in power, ports and highways, represents the results of a belief that autocracy is not necessary to achieve rapid economic growth.

Of the 31 countries out of 38 that did not change status in the last 110 years, 17 were classified as developed in 1900 and still are classified as such, and 14 were classified as emerging and remain in that category 110 years later. Thus, while GDP per capita has grown considerably in these countries, their relative rankings have changed far more slowly.

Many reasons explain why emerging markets have not emerged more rapidly, including dictatorship, civil war, corruption, wars, communism without Chinese characteristics (the latter including such features as private ownership of property, companies being allowed to make and retain profits and a relatively high degree of economic, though not political, freedom for individuals), hyperinflation and disastrous economic policies. Dictatorships, which were particularly prevalent in Latin America during the 20th century, but also arose in such European countries as Portugal under Salazar, Spain under Antonio Salazar Francisco Franco and Italy under Benito Mussolini, tended to promote inward-looking policies featuring high-tariff barriers and subsidies to favored domestic industries. These benefited groups that supported the regime at the expense of efficiency and openness to outside influences, but helped maintain the dictatorship's grip on power.

Wars generally have negative effects on economic growth, especially for the losers, but sometimes also, as with the case of the United Kingdom after the Second World War, for the victors as well. Only when a country is geographically isolated, such as the United States, Australia or South Africa, does involvement in a war tend to benefit nations. Civil wars, such as those which occurred in Spain from 1936 to 1939, China from 1928 to 1949 and Russia from 1917 to 1922, are particularly disruptive to economic progress, as they both destroy economic capacity and lead to many of the country's most intelligent and dynamic citizens being killed, imprisoned or driven into exile.

Communism, with its disastrous economic policies of rigid central planning, prohibition of individual enterprise and valuation of party loyalty above competence, ensured that Russia remained economically backward for most of the 20th century, as did Eastern Europe from 1945 to 1989 and China from 1949 to 1979, when Deng Xiaoping introduced a modified form of capitalism (communism with Chinese characteristics).

Finally, governments resorting to the printing press to attempt to solve economic difficulties, whether Weimar Germany from 1922 to 1923, Greece and Hungary from 1944 to 1946 or Argentina, Brazil and Peru from 1989 to 1990 and Zimbabwe from 2007 to 2010, lead to the destruction of savings and a collapse of investor confidence needed to fund investment.

Argentina, which experienced dictatorship under Juan Peron, hyperinflation in the 1970s and 1980s and an unsuccessful foreign war, in 1900 had a GDP per capita equal to France's and higher than Sweden's and Norway's and was one of the five wealthiest countries in the world. Having suffered through this combination of misfortunes particularly since 1950, it has now been relegated to frontier market status by MSCI (in 2009). Several Eastern European markets that were moving toward becoming developed markets in the early 20th century, such as Poland, Hungary, Czechoslovakia and Russia, were hit by the double blow of two world wars and communism.

Unforeseen crises aside, the path to successful economic development is by now widely known and easy to follow if the political elite in a country has an interest in doing so and is willing to overcome the opposition it will face from existing stakeholders. It involves a few major steps such as carrying out a program of land reform to give clear title to small landowners in the agricultural sector and reducing internal and external tariffs and customs duties to encourage the free flow of goods. Other prerequisites include a relatively transparent legal system not dependent upon the whims of the ruler and a focus on raising educational standards so that the workforce required for industrialization is literate and numerate, enabling it to function effectively in an industrial society.

The rule of law, including the recognition of property rights, and the free movement of goods and labor are the necessary underpinnings of economic takeoff. While additional benefits such as provision of a reasonable standard of health care, recognition of workers' rights and a clean environment are desirable in an emerging (or indeed any) economy, they are not vital.

As noted previously, the MSCI Emerging Markets (Free) Index, the best-known index for these markets, has more than doubled over the last decade. Through the 10 years ending October 31, 2012, it returned 85.6 percent in U.S. dollar terms, or a total return of 133.6 percent with dividends included, equivalent to 8.9 percent per annum (p.a.). This is despite the perceived riskiness of investing in markets and economies that can be very volatile, where political risks are high, and the quality of information available is low.

The reasons for their outperformance, compared with developed markets, which have returned less than half this amount over the same period, are perfectly straightforward. At the beginning of the last decade, emerging markets were cheap: their valuations were at low levels after the Asian crisis of 1997–98, the Russian default of 1998, the devaluation of the Brazilian real in 1999 and the Argentinean default of 2001. However, their underlying fundamentals, the principal reason for investing, remained attractive. We believe the same situation applies to frontier markets today, where the frontier market index has rebounded only half as much as either the emerging market or, indeed, developed market indices since the financial crisis of 2008–09.

As is the case with frontier markets today, these markets were countries with young populations, low social costs in the form of low or no government expenditures on unemployment payments and pensions, high levels of domestic savings due to the absence of a government safety net in the form of unemployment payments or pensions, rising living standards as they industrialized and improved competitive positions through currency positioning and devaluation.

As a result, they have enjoyed a decade of improving GDP and rising incomes, while also running balance of trade surpluses and keeping government spending under control. Their stock markets have reflected these improvements and delivered excellent returns to shareholders, although fast growth in an economy is not always reflected in stock prices, an economic principle demonstrated by China.

The improvement in the financial situation of the emerging markets is reflected in their credit ratings by the major agencies, where by the end of 2010 57 percent of the JP Morgan Emerging Market Bond Index was investment grade (rated BBB or above), compared to 34 percent in 2002 and only 5 percent in the late 1990s.

By purchasing a fund with broad geographical exposure to these markets, whether actively managed or a passive index fund (the diversification helps to avoid undue exposure to problems in one region or another, such as the Arab Spring of 2010–11), investors will be able to benefit from these trends as they continue for the next few years.

The growth of the middle class in the emerging and frontier markets will also benefit commodity producers in developed countries, such as Australia and Canada, and emerging and frontier commodity producers themselves, particularly those with a major resource sector such as South Africa, Indonesia, Brazil and Colombia.

One additional point to bear in mind is that the improving fundamentals of emerging and frontier markets are reflected in their currencies, which have tended to at least hold their own, if not appreciate gradually, against developed market currencies over the last decade. This reflects their improving fundamentals and superior demographic profile compared to the aging and debt-encumbered Eurozone, Japanese and U.S. economies. Over the past decade, the Chinese Renminbi has appreciated against the American dollar, the Mexican peso and the Brazilian real.

Frontier Markets

Frontier markets comprise the approximately 60 countries that are not included among the 25 developed stock markets or the 21 emerging markets that we discussed in the previous section. Both MSCI and S&P have frontier market indices, and those 40 countries included in the indices from both index providers are as follows:

Sub-Saharan Africa

Benin

Botswana

Burkina Faso

Ghana

Kenya

Ivory Coast

Mauritius

Namibia

Nigeria

Senegal

Zambia

Asia

Bangladesh

Kazakhstan

Pakistan

Sri Lanka

Vietnam

Europe

Bulgaria

Croatia

Estonia

Latvia

Lithuania

Romania

Serbia

Slovakia

Slovenia

Ukraine

Latin America

Argentina

Colombia

Ecuador

Jamaica

Panama

Trinidad and Tobago

Middle East and North Africa (MENA)

Bahrain

Jordan

Kuwait

Lebanon

Oman

Qatar

Tunisia

United Arab Emirates (UAE)

This list of countries includes Colombia, which also appears in the emerging market indices. There are another 45 to 50 countries not included in the index providers' frontier indices, which have been described by some investors as exotic frontier markets. They have smaller market capitalizations, lower liquidity and price-to-earnings (P/E) ratios and lower correlation with major developed markets than those countries in the frontier market indices.

These include some quite sizable or resource-rich countries such as Azerbaijan, Belarus and Macedonia in Europe; Angola, Tanzania and Zimbabwe in Africa; and Iran, Iraq and Saudi Arabia in the Middle East. Politics, lack of liquidity or restrictions on foreign ownership exclude them from being included in the indices.

The argument for investing in frontier markets may be stated very simply. Their economies are at a stage of development similar to where the emerging markets were 10 to 15 years ago, and it is highly probable that they will follow the same path of economic development as the emerging markets.

This in turn should be reflected in the performance of their stock markets. In the same way as the emerging markets proved over the last 15 years, from 1998 to 2013, frontier markets will become extremely rewarding investments.

The reason for believing that the frontier markets will likely prove to be rewarding investments is not that high rates of GDP growth will necessarily be reflected in their stock markets, as we discuss in Chapter 4. The reason is that they are attractively valued with a price-to-earnings ratio of 10.3, price-to-book ratio of 1.38 and dividend yield of 4.1 percent (September 2012), which matches where the emerging markets were at the beginning of the last decade.

In addition to being valuable because of their potential income, frontier markets are also a good investment choice because they are not highly correlated with other major stock markets or the other emerging and frontier markets; therefore, although volatile themselves, adding them to a portfolio will reduce its overall volatility.

Frontier markets, moreover, look attractively valued by comparison with emerging and developed markets. This is to be expected, given their lower level of economic development, lack of liquidity and small size. Nonetheless, the MSCI Frontier Markets Index, which lost two-thirds of its value during the global financial crisis of 2008–09, slightly worse than the emerging and developed market indices, has recovered to only about half the level of its 2008 high in the last four years, as opposed to the other global indices, which recovered almost all of their losses. This fact makes them good candidates for investment, as the frontier market economies have continued to grow strongly through this period, in some cases growing more rapidly than the established emerging markets such as Brazil, Russia and India. With more domestically oriented economies, they have been less affected by the slow and patchy GDP growth displayed by the developed economies, especially Europe and Japan, since the financial crisis of 2008–09. Furthermore, as standards of corporate governance improve and access to foreign capital becomes easier, frontier market listed companies are demonstrating strong growth in earnings as they are able to invest newly available capital in attractive opportunities.

Through August 31, 2012,