‘Final frontier boosts returns’

With UK investors once again looking further afield for decent returns, Ian Orton investigates how frontier markets could diversify portfolios and boost profits

Investing in emerging markets – the precursor to frontier-market investing – has provided a solution to the challenges of low returns since the middle years of the 19th century.

In the 1868, the Foreign and Colonial Investment Trust (FCIT) became the first pooled vehicle to allow investors access to more exotic and higher-yielding investments. Back then, it was stuffed with what would now be called emerging market bonds. The investment trusts that followed in FCIT’s wake had a similar emerging market bias, with the United States a particularly favoured destination.

All these years later and many former emerging markets, including the US along with more newly “emerged” markets such as the so-called BRICs – Brazil, Russia, India and China – have entered the investment mainstream for both bond and equity investors. But just like the 1860s, albeit for different reasons, the search for both enhanced returns and additional portfolio diversification has continued unabated.

According to some investment strategists and managers so-called “frontier markets” could be well-placed to provide a suitable solution.

Frontier markets performed well in 2012 – and have so far this year – in both absolute and relative terms. Notably they outperformed “conventional” emerging markets. The MSCI Frontier Markets Index, which consists of 25 “frontier markets”, produced a return of 7.48 per cent during January 2013, compared with the 1.39 per cent returned by the MSCI Emerging Markets Index. Over one year, the MSCI Frontier Markets Index generated a return of 16.76 per cent compared with the 8.01 per cent recorded by the MSCI Emerging Markets Index.

Consumers in emerging and frontier markets look set to become the prime source of equity market returns

Unfortunately, the longer-term record is not quite so good, at least as measured by the MSCI indices. Over the preceding three, five and ten-year time periods to the end of January 2013, frontier markets posted returns of 6.75 per cent, -9.21 per cent and 8.93 per cent respectively. This compares to 7.5 per cent, 2.35 per cent and 17.1 per cent returned from emerging markets over the same time periods.

In addition, frontier markets trail many developed market indices. The MSCI World Index produced three, five and ten-year returns of 10.88 per cent, 2 per cent and 8.96 per cent, for example.

It should be noted, of course, that the MSCI Index does not fully represent the entire universe of equity markets falling within the definition of “frontier markets”. Frontier markets are defined as investible markets that have both lower market capitalisation and liquidity than the more developed emerging markets.

Nonetheless, the argument for frontier markets doesn’t look quite so compelling, even if some of them are among the fastest growing economies in the world.

Sam Vecht, the lead manager of BlackRock Frontiers Investment Trust, which had around $146.2 million (£92.3 million) of assets under management at the end of January 2013, cites compelling reasons for equity investors, especially relative to conventional markets.

He says: “Frontier markets not only provide much better value in terms of company valuations, they also offer much better dividend yields.

“Frontier market companies, focused on domestic growth, often trade at single-digit multiples. For emerging market companies, the multiples can often be as much as 25 times earnings.

“In part, this stems from the fact that the global-investor universe has yet to discover frontier markets. Dedicated emerging market investment funds currently hold around $850 billion of assets. But dedicated frontier market investment vehicles hold around $10 billion.”

Interestingly, frontier markets can also be less volatile than emerging markets. Mr Vecht says this is because they have been far less affected by big global events, such as investor concern about the implications of a US fiscal cliff. Also there is a much bigger universe of firms to consider drawn from a hugely varied set of markets. This is especially the case for investors like Mr Vecht whose investment universe is not constrained by any particular index.

Citing specific examples, Mr Vecht’s investment case for frontier markets is convincing.

He explains: “There are some very exciting opportunities available in markets like Iraq, for example, where despite the obvious challenges, the risk-return trade-off looks very compelling.”

However, other professional investors offer additional reasons for considering this sector as a potential addition to a portfolio. There are secular reasons for suggesting that frontier markets should provide much greater opportunities in the years ahead for investors.

According to analysts at HSBC this stems from the fact that consumers in emerging and frontier markets look set to become the prime source of equity market returns. This is especially the case for countries like China, which is attempting to balance its economy away from its dependence on exports and infrastructure investment to higher consumer spending.

The good news for frontier markets, according to HSBC, is they have a much bigger representation of consumer-facing segments than emerging markets (60.1 per cent of market capitalisation versus 43.6 per cent).

In addition to BlackRock’s Frontiers investment trust (IT) there are a number of London-listed vehicles that provide both diversified and single-country exposure to frontier markets.

Both the BlackRock Frontiers IT and Advance Frontier Markets Fund (ADMF) provide diversified exposure to the universe: the former primarily by investing in single securities, the latter by adopting a fund of funds approach. London-listed single-country frontier market funds provide exposure, inter alia, to Qatar, Ukraine and Vietnam.

There are also emerging market closed and open-ended funds that provide diversified exposure to frontier markets from long-establishment investment management houses, such as Aberdeen Asset Management, Fidelity, Franklin Templeton and JP Morgan Asset Management. If none of these take your fancy, RBS also offers a London-listed index linked certificate that tracks the MSCI Frontier Markets Index.

WHERE ARE THE FRONTIER MARKETS?

The 25 constituent countries of the MSCI Frontier Markets Index are Argentina, Bahrain, Bangladesh, Bulgaria, Croatia, Estonia, Jordan, Kazakhstan, Kenya, Kuwait, Lebanon, Lithuania, Mauritius, Nigeria, Oman, Pakistan, Qatar, Romania, Serbia, Slovenia, Sri Lanka Tunisia, UAE, Ukraine and Vietnam.