Frontier equities delivering on promise of risk diversification
While emerging market equities have been taking a battering, their diminutive near-relative frontier market equities have been holding up rather well, seemingly immune to the headwinds buffeting the interconnected jigsaw that makes up the global equities market.
Funds have continued to flow into fast-growing markets in about 30 countries in the Middle East, Africa and Asia with pockets in Latin America and Eastern Europe, while Bric equities funds have been posting net outflows all year. While EMs sold off in response to the Fed’s June announcement of its timetable for tapering QE, frontier year-to-date returns are still up around 12% while EMs are down around 9%. Frontier equity funds have seen inflows of almost $3 billion this year, according to EPFR.
Frontier equities offer cheaper valuations, higher return on equity and lower volatility than EMs equities. Add in GDP growth in frontier economies that the IMF forecasts will match that of EMs – around 4.5% – during the next four years and it’s easy to see why the asset class’s performance and economic potential is making investors once again sit up and pay attention.
What’s particularly surprising about the bullish frontier equity cycle is that it coincides with the EM risk-off environment, a rare de-correlation, and the Egypt political crisis, which highlights the event risks associated with developing economies with young populations.
Nevertheless, frontier markets have regained their reputation as a diversification hedge from global economic shocks – an investment pitch that admittedly failed in the post-Lehman rout – as these markets substantially outperformed their more liquid and crowded EM cousins in the recent global sell-off.
As a result, fund managers are gaining traction with clients with the oft-touted investment pitch, citing the structural economic potential of frontier markets. What is getting so many investors and fund managers so excited is that, in many respects, frontier markets look like EMs did 20 years ago.
Total frontier market capitalization is about $1 trillion compared with EMs’ $6 trillion and less than 1% of the global equities market. The sector remains virtually untouched by international institutional investors, which account for an estimated $10 billion to $40 billion (1% to 4%) of the market, compared with about $1 trillion following EMs, according to BlackRock.
This makes for low volatility and low correlations to emerging and global markets because these assets are not the same as those following these markets.
Frontier markets also have low correlations to each other. One of the main reasons they dance to their own tune, according to Julie Dickson, a portfolio manager at Ashmore, is that their economic growth is almost entirely domestically led, driven by a combination of strong corporates that generate most of their revenue at home, favourable demographics, expanding middle classes and rising disposable consumer-incomes.
“One of the factors that has made these markets so attractive to investors and what has led them to outperform quite strongly this year is the degree of dividend deals you can extract from companies,” she says.
“You’ve got good companies that could be delivering in excess of 5%, 7%, even 10% dividend yields consistently every year and there are plenty of them out there.
“Also driving returns in the Middle East, and especially Africa, has been the expansion of western multinationals in to the continent precisely because of the strong consumer spending growth.”
Emily Fletcher, co-fund manager of the BlackRock Frontiers Investment Trust, believes frontiers offer the most interesting opportunities because in addition to strong growth, cheap valuations, high dividend yields, and low correlations and volatility, they are under-researched.
“It’s really that institutional following and that hot money in EMs that drives the higher correlations between emerging and world markets, whereas correlations are much lower between frontier markets,” she says.
“Lower volatility is something that we saw borne out to be true, especially in the last month, when volatility continued to be lower than in EMs.
“The reason frontier markets, as a whole, have a lower volatility is because what’s going on in Nigeria has very little impact on what’s going on in Pakistan; what’s going on in Kazakhstan has very little impact on what’s going on in Qatar, and the investors, very often, in these local markets are not the same across each market.
“It’s that difference which means that the diversification benefits of frontier markets are still very much there in a way that’s no longer true in EMs because the investor base has become so similar.’’
Fletcher adds that during the past 12 months, BlackRock Frontiers Investment Trust has been increasing positions in south and southeast Asia, including Bangladesh, Sri Lanka and Vietnam, and expects to continue to add to these positions over the medium-longer term.
Frontier markets are often assumed to be developing economies, and while many are, there is a huge variation from the poorest – Cote d’Ivoire, Bangladesh – to virtually first-world countries such as Argentina or Slovenia.
According to World Bank data, per capita income ranges from low, less than $1,025; to high, more than $12,476. Three-quarters fall into the middle-to-high income bracket.
Providers of equity indexes, such as the S&P Frontier Broad Markets Index, define frontier economies as those where the political and market environment requires substantial improvement.
They usually lack the size, depth and breadth of developed financial markets and robust accompanying legal and regulatory infrastructure, all of which impacts the ability of foreign investors to do business.
However, there is huge variation. Market capitalization, for example, ranges from $5.5 billion for Bulgaria to $108 billion in Kuwait.
One of the issues frontier markets face is a lack of liquidity, which inhibits the ability of investors to enter and exit a market while distorting pricing during particularly illiquid sessions.
An even bigger question mark is about the assumption that economic growth will logically translate, over time, into earnings growth.
Research by Vanguard Investments has found there is little correlation over typical investment horizons and that it is growth surprises that are more important for higher market returns – when actual growth exceeds expected growth.
Globalization and valuations – the amount investors pay for expected growth – also factor highly in market returns.
Here too there is disagreement between fund managers, who argue valuations are low, and analysts, who are sceptical as to whether many price-earnings ratios are justified by the fundamentals.
“We are starting to get a bit more optimistic because we think valuations are becoming a bit more realistic,’’ says Ronak Gadhia, Africa equity research analyst at Exotix in London. “At the very least we don’t see significant downsides – the market should stay flat, if not go up.
“Even after the recent sell-off, the price-earnings ratios for frontier and EMs are virtually neck and neck. Now it’s just really a case of which asset class will grow faster.”
He adds: “A lot of what’s going on could just be a question of liquidity. It’s a lot easier to get in and out of Turkey, South Africa, India, China; not that easy to get back in to frontier markets once you’ve sold. So you’re taking a long-term view on this market and if you believe economies are going to continue to do well you’re willing to hold your positions.
“With economies growing at about 5% and inflation at about 5%, in nominal terms earnings should grow at 10% or higher because typically in emerging frontier markets earnings grow at a multiple of GDP growth. So if you’ve got price-earnings of 11 and growth is 10% or 12%, you’re looking at a price-earnings to growth ratio of less than one, which is quite attractive.’’
However, investing in frontiers comes with risks, including political instability in markets such as Lebanon, Tunisia and Bahrain, and corporate governance issues in firms in countries such as Nigeria, Pakistan and Kazakhstan, which score very poorly on Transparency International’s corruption index.
Dickson of Ashmore concludes: “There’s a tremendous amount of homework that needs to be done to identify which are the opportunities from the ones that might have some potential corporate governance issues.