In 2013 frontier markets surged, seemingly out of nowhere. Nick Fitzpatrick asks fund managers why it happened.
Perhaps unbeknown to them, sharia law has benefited a broad set of frontier market investors.
The frontier market sector has surged recently and Islamic nations are a significant part of this risky equity universe. Companies in these countries seek to pay substantial dividends to a mainly local, Muslim shareholder base. Dividends act as an alternative to offering interest-bearing securities, which Islam prohibits.
Yield-hungry international investors who were in frontier stocks and funds in 2013 have been lucky. Almost out of nowhere, it seems, frontier stock markets increased in value last year as new investment poured into them. The MSCI United Arab Emirates index returned 79% year to date December 24 in dollar terms, according to MSCI data. The MSCI Pakistan index returned 28%.
Thirteen stocks in the Karachi 100 were up more than 100%.
At the same time, emerging market investments decreased in both fund flows and returns.
Dividend opportunities may partly explain the interest in frontier markets, where inflows in the fourth quarter of 2013 were worth some $618 million (€447 million) according to EPFR Global, compared to an outflow of $576 million from the more established Brazil, Russia, India and China (Brics) emerging markets sector.
Emily Fletcher, of BlackRock’s alpha strategies group, says: “Dividends are typically high in frontier markets. A high proportion of frontier countries are Islamic where there is a prohibition on interest, and companies have typically paid a good dividend yield.”
The dividend yield on the underlying stocks in the BlackRock Frontiers Investment Trust is 4.1%, for example.
But there is also a broader structural reason for higher dividends.
Andrew Brudenell, portfolio manager in the frontier markets team at HSBC Global Asset Management, says: “Frontier market companies are cash-generating due to the nature of their shareholders, who are domestic owners, like governments and families. They want an income from their enterprises because financial services products in these regions are limited and it is hard to get income from these products, apart from real estate.”
The HSBC GIF Frontier Markets fund had a dividend yield of 4.2% at the end of 2013.
But there have been broader reasons to invest in frontier markets beyond the twin aspects of sharia law and the paucity of high street banking products paying interest.
For some investors, the great bulk of funds in emerging markets were too prone to wobbling each time Bernard Bernanke, the Federal Reserve chairman until January this year, or Angela Merkel, the German chancellor, spoke.
“Frontier markets are driven by local factors rather than what’s happening with tapering in the US,” says Michael Levy, fund manager of the Baring Frontier Markets Fund, referring to the reduction in the Federal Reserve’s bond purchase programme.
Fletcher says: “Many emerging market investors were playing the carry trade and these markets suffered from talk about tapering.”
Tapering is expected to see rates rise and, in the process, this could hurt “carry traders” who borrow in the US to invest in higher yielding emerging countries.
The correlation of the MSCI Emerging Markets Index with the S&P 500 was 0.8, and this compares to a 0.4 correlation between the S&P 500 and the MSCI Frontier Markets Index at December 31, 2013, based on five weeks of weekly data.
Figures that BlackRock provides as an indication of investment sizes show that at the start of 2013 international institutional investors had a sum of roughly $1 trillion committed to emerging markets out of a universe of $5-6 trillion. In contrast, they hold around $20 billion of assets in frontier markets within a universe of around $1 trillion.
“The proportion of assets held by institutional investors is higher in the emerging markets and this is a reason why we’ve seen a difference in performance,” says Fletcher. “Correlations in frontier markets, both between themselves and with the rest of the world, are lower.”
As far as Fletcher sees it, inflows to frontier markets are explained partly by investors who see the benefit of holding equities in countries with broadly similar profiles to emerging markets – at least in their potential for high growth – yet are trading at a discount. Also, they may recognise that these stocks have more immunity to developed-market monetary policy.
Things started slowing down for emerging markets in the second half of 2010, says Brudenell, and the decision process for equities became more complex in 2011. But whereas emerging market economies were beginning to overheat, frontier markets were not and their outlook was improving.
Dubai managed to put its 2009 debt crisis behind it and Middle East tourism increased there as people avoided nearby countries where tensions were running high.
In 2012, Pakistan elected its second civilian government, which was seen as a great boon for that country.
More broadly, transparency has spread, the amount of non-performing loans has fallen, and corporate earnings have increased, says Brudenell.
The HSBC GIF Frontier Markets Equity fund generated an absolute return of 28.6% in 2013, outperforming its reference index by 11.1% on a gross basis, over the calendar year.
Total assets under management for the HSBC frontier markets equity strategy was $505 million, as at the end of December 2013.
But can investment returns hold up after a storming year?
Brudenell says this year will be about stock picking. In 2009, he notes, the fund returned 42% against a benchmark of 12%, indicating alpha can be created through active management.
“In 2012 a lot of companies were trading at 4x to 5x forward p/e [price/earnings] ratios. They are now near 7x to 8x after earnings have grown significantly. We still see a lot of value in a lot of names in frontier markets but you have to be more of a stock picker than you were a couple of years ago.”
On a book value basis, some companies have re-rated from 0.5x book value to between 1x and 2x, “but they are still not expensive”, Brudenell says, “and their return on equity is good”.
He adds there are opportunities in the Middle East and frontier Asia, but warns that a key risk is a big change in the oil price in the order of $50-$60. “Then budgets will have to be cut back and exporters will struggle a bit, but it varies between countries.”
Having the same profile as emerging market countries can in some cases also mean current account deficits, but fund managers say deficits in frontier markets are less likely to be internationally funded, meaning wild flows of foreign capital, or “hot money”, like that seen in Brazil in recent years with destabilising effects are not responsible for the imbalances.
“It is not a surprise that frontier markets have current account deficits because they are rapidly growing, but funding is typically much more robust,” says Levy, adding there are strong levels of foreign direct investment.
Nevertheless, Fletcher is not expecting the dramatic performance of the UAE to be repeated in 2014. She says the BlackRock trust is reducing exposure to the Middle East and increasing to South East Asia, Eastern Europe, South and Central America.
Levy says he is very positive for Nigeria, and he highlights banking which he expects to benefit as usage of current accounts and credit cards spreads. “We expect frontier markets to be driven by domestic issues rather than the global factors, although frontier markets will not be totally immune from any significant developments surrounding the global economy.
“We believe frontier markets continue to offer strong growth opportunities at a reasonable relative valuation and in our view offer investors one of the most compelling long-term opportunities within the equity markets.”
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