November 2011

INSIDE VIEW: Emerging from the frontier

Footprints-in-the-sandInvariably overlooked because of the incorrect perception that they enjoy greater risk, frontier markets are slowly providing evidence of their worth. Bud Haslett of CFA Institute investigates.
Emerging markets have been an important part of the investment landscape for decades. With the multitude of securities now residing in this classification, where were these investments before they became emerging? Typically, we need to look no further than the frontier markets to find the answer to this question. According to Larry Speidell, author of the book Frontier Market Equity Investing: Finding the Winners of the Future, frontier markets are found in those 60 or so countries with stock markets too small to be included in the MSCI emerging markets universe. All stock markets were at one time or another considered frontier, including all markets outside Europe 300 years ago. Why might frontier markets warrant further investigation from the astute funds manager?  According to Speidell, there are many reasons. One of the most important is that these markets represent favourable valuations because they are often overlooked owing to the perception of greater risk. The reality of the situation is frontier market risk is no greater than the risk in many markets we consider to be emerging. A good proxy of this risk can be found by examining the economic freedom data provided by the Heritage Foundation. This information analyses attributes such as business, trade, fiscal, investment and labour freedom in addition to property rights and corruption. The organisation then ranks countries according to their scores on these metrics.  Speidell’s analysis of these rankings shows the frontier markets do not really represent a step down in quality from emerging markets but rather more of a lateral move into neglected markets. These neglected markets can provide many opportunities for the diligent manager. Other fundamental convictions Speidell finds for entering frontier markets include improving politics and policies in many of the countries. This is evidenced by more peaceful transitions of power and more actively utilised advice from global organisations such as the World Bank and the International Monetary Fund. Flows of capital into the frontier countries are also rising. This is often because of the abundant natural resources that are largely underexplored. Frontier markets also have strong growth of a young population, with the exception of Eastern Europe. This growth, combined with low labour costs and rising levels of education, provides a catalyst for a productive workforce. This also leads to greater output and eventual future demand for products and services. Often, frontier countries can leapfrog over generations of world technology to newer, more effective telecommunications and scientific know-how. This enhances the countries’ development. From the perspective of a portfolio manager, frontier market stocks often provide better diversification benefits than emerging markets. This is because of their low correlation among other frontier stocks, emerging market stocks and traditional investments as well as relatively low level of volatility compared to emerging markets.  Despite all the apparent benefits from frontier market investing, there are challenges to be found. The amount of research in frontier markets is limited and often poor in quality.  In addition, quantitative tools are often misused and must be carefully constructed and evaluated because of the nuances of the marketplace. Liquidity still seems to be a challenge with trading levels inadequate to allow for a more efficient allocation of capital but, as Speidell says, this also indicates the markets are not being fully exploited.   Essentially, when one makes an investment in frontier markets, one is faced with the challenge of buying today’s price and tomorrow’s liquidity, according to an associate of Speidell’s. Satisfaction and optimism
Just as markets grow and mature beyond the frontier and into emerging and developed markets, the path is not always a one-way road to success. Some countries actually lose their status as emerging markets and fall back to the frontier markets. Pakistan, Argentina and Sri Lanka are recent examples and it may occur to several others should the global economic malaise continue. From a personal perspective, a compelling attribute of frontier markets is the spirit of the people. With a high work ethic, a sense of entrepreneurship, and a developing middle class, Speidell believes a strong foundation is laid for future economic gains. A recently conducted survey by the Pew Foundation found that life satisfaction is directly related to per capita gross domestic product, while optimism that our children will have a better life than us is inversely related to income. This is evidence of the optimism that abounds in the smaller countries that comprise the frontier markets. Even with the uncertainty and challenges facing the global economy, Speidell believes that much of the rewards in the future will come from those who have the most to gain. These are exactly the people and companies that are emerging from the frontier markets. Bud Haslett is a chartered financial analyst and head of risk management, derivatives, and alternative investments at CFA Institute, Charlottesville, Virginia ©2011 funds europe

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