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Magazine Issues » October 2014

FRONTIER MARKETS: The frontier gates are hard to open

VietnamFrontier markets are hot, but what enthusiasts rarely mention are the complexities involved in accessing these assets. George Mitton reports.

An exciting event for frontier market investors is scheduled for the first half of next year, when Saudi Arabia opens its stock market to direct investment from qualified foreign institutions.

The country’s bourse is one of the last major stock markets to open to foreigners and is huge, by frontier market standards. If it were to open fully, it would have a weighting of more than half the MSCI Frontier Market index.

However, the stock market will not open fully, at least not at first. The Saudi authorities have devised a range of caps to limit foreign inflows into the country, including a threshold of $5 billion (€3.8 billion) under management to qualify as an investor and caps on the amount of shares that foreign institutions can own.

These limits may prevent MSCI from promoting Saudi Arabia to an emerging market and are emblematic of problems common to frontier markets, where investors must negotiate a range of restrictive rules.

What are the main problems and how can they be overcome?

Another frontier market where foreign investors are confronted with ownership limits is Vietnam. This fast-growing market has a capitalisation of $57 billion spread across the two exchanges of Ho Chi Minh City and Hanoi. Foreign investors play an active role, accounting for $13 billion of portfolio values, according to a statement by Vietnam finance minister Dinh Tien Dung in July.

However, the ability of incoming foreign investors to make the most of this market is curtailed. Take the dairy company Vinamilk, worth some $5 billion, which is “the stock everyone loves to own”, according to Dominic Scriven, chief executive of Dragon Capital, a Vietnam-based asset manager. The problem is that every stock in Vietnam is subject to a 49% foreign ownership limit and Vinamilk is generally at or close to its limit at all times, meaning that an incoming foreign investor may not be able to buy shares.

The problem is acute for exchange-traded funds (ETFs). There are two main foreign ETFs focusing on the Vietnamese equity market, one from Van Eck Global and one from db X-trackers. These offer convenient, liquid access to the Vietnamese equity market for foreign investors but, says Scriven, they are hamstrung by foreign ownership limits.

“In Vietnam, the stocks everyone loves are mostly fully foreign-owned, therefore, ETFs that need to slot capital in and out are unable to do that,” he says. “They have to create their own indices which takes them away from the core index. Inevitably, there’s a risk that by focusing on what they can invest in, they focus on what others don’t want.”

The bespoke indices the ETF providers create exclude some of the most popular stocks, and have an in-built tendency to underperform compared to unconstrained managers. The performance difference can be 10% over a three-year period, says Scriven. Even worse, the ETFs have a tendency to “cannabalise” themselves. When the ETFs receive an inflow of capital, they buy the stocks in their index. But when they face redemptions, they sell those same stocks.

One solution for foreign investors is to invest their money with a Vietnam-based asset manager that isn’t subject to foreign ownership limits. Dragon Capital has an interest in a newly launched, Vietnam-domiciled ETF that will give investors liquid exposure to the country’s stock market without restrictions faced by the foreign players.

There are a multitude of other challenges facing frontier market investors, though. Frontier markets often suffer from asymmetry of information – they do not have the disclosure and governance standards that investors can expect in developed markets.

Then there are limits to the market’s breadth. Vietnam has 680 listed companies but about 650 of them are less than $200 million in value, says Scriven, which leads to a “distorted universe” with odd weightings.

Perhaps a bigger problem concerns the treatment of shareholders. Even assuming shareholders’ rights are protected, which is not guaranteed in markets where regulation is young and evolving, investors in frontier market companies may find their shareholdings diluted, wiping out market gains.

This is a pattern that happened in emerging markets, such as India and Brazil. Richard Carlyle, investment specialist at Capital Group, says that in the run-up to the Asian crisis, emerging market companies registered impressive growth in sales, but also had huge needs for financing, which they met by issuing new shares.

“It didn’t make shareholders richer because companies were issuing new shares to pay for financing,” he says. “Financing needs were great, shareholders were not rewarded. 

“The next ten years for the frontier market world could repeat what happened in emerging markets. African firms may have 25% sales growth, but if they issue 25% more shares, you don’t gain.”

Carlyle urges a cautious approach to frontier markets generally. Although a very long-term investment in the likes of Bangladesh or Nigeria ought to yield returns, it will be a bumpy ride. In the meantime, investors are faced with a limited opportunity set – the MSCI Frontier Market index is tiny compared to the Emerging Market index – and they may find their investments are more subject to fluctuations in, for instance, the oil price, than they would like. If this seems surprising, consider that the largest weighting in the MSCI Frontier Market index is Kuwait, a country which gets 93% of its GDP from hydrocarbons.

However, with regard to the specific complaint of foreign ownership limits, Carlyle offers an apposite comparison. It is not only places like Saudi Arabia and Vietnam that limit how much foreigners can own of their national industries. In the UK in the past, there was a foreign ownership limit on aerospace firm Rolls-Royce.

“It’s not unique to developing markets,” he says. “Countries feel vulnerable if defence industries are in foreign hands.” 

The headaches of frontier markets are not limited to investors and asset managers either. Asset servicing firms also face complexities when dealing with these markets. 

In frontier markets, regulations are often not as clear as in developed countries, and with regard to questions such as asset ownership, this can create problems, which have intensified under recent European regulation such as the Alternative Investment Fund Managers Directive (AIFMD).

Specific to asset servicers is the depositary liability written into the directive, which means companies such as BNP Paribas Securities Services have to take responsibility for alternative funds’ assets.

“The risk is not new,” says Jean Devambez, global head of product and solutions, asset and fund services at BNP Paribas Securities Services. 

“But the AIFMD has brought a lot of new issues. We now have an assessment on every country where our clients invest. It’s made of legal opinion, reviews, and it takes time,” Devambez says.

The question is determining in which countries the market infrastructure is sufficient to give full ownership recognition. 

In some markets, the collected legal opinions and reviews are not enough to satisfy the firm that its rights will be protected. In some extreme cases, Devambez says the firm would decline to support a client in a certain country if the restitution risk was too high.

The accumulated difficulties with investing in frontier markets can seem daunting. But if investors feel discouraged, they should remember that the rewards can be great. Plus, if frontier markets were easy to invest in and carried only few risks, they probably wouldn’t be called “frontier”.

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