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What do Argentina, Bangladesh, and Kazakhstan have in common?

They are classified as frontier markets, a subset of emerging markets that are deemed even riskier and less liquid. As a result, their valuations tend to be cheap, the promise of growth great—and today, their returns are surging.

From May 2016 to May 2017, Argentina’s Merval Index skyrocketed 64%, Bangladesh’s DSE General Index gained 25%, and Kazakhstan’s Stock Exchange Index KASE rose 60%.

In addition to the promise of extraordinary gains, some portfolio managers invest in these markets as a means to manage their overall portfolio risk.

How so? Emerging markets are increasingly correlated with developed markets through fund flows as the global economy becomes more interconnected where political or economic issues in a developed country can affect an emerging one. Frontier economies, however, are less attuned to global market moves.

For instance, frontier markets returned 3.2% last year according to the MSCI index, compared to 11.2% return by the MSCI Emerging Market Index and 8.1% by the MSCI World Index during the same period.

“Frontier markets tend to be invested by local investors rather than international institutional investors, and as a result, frontiers tend to not move at the same time as other markets and tend to be driven by local events,” said Emily Fletcher, an emerging- and frontier-markets specialist with BlackRock.

And this low correlation relative to other markets makes frontier markets attractive to some investors.

So Why the Lag?
In the past three years the MSCI Frontier Market Index has lost 2.66%, compared to a 2.16% gain for the MSCI Emerging Market Index and 6.27% for the MSCI World Index.

“It has been a very sluggish asset class in the past couple of years, and it is related to oil or political factors,” said Pradipta Chakrabortty, a portfolio manager in New Jersey.

“And those are the biggest risks to consider when investing in frontier markets.”

Oil prices plummeted in mid-2014 due to oversupply and weak global demand, decelerating growth in oil-producing economies and pushing some into recession.

“With oil slumping and with a large chunk of the frontier benchmark exposed to oil-dependent countries like Kuwait and Nigeria, the overall sentiment hardened,” said Chakrabortty.

The lag in positive returns in frontier markets has also been due to the lack of liquidity, or the difficulty in finding buyers or sellers of stocks in small markets at a stable value, and more so when the tolerance for risky assets diminish on a global scale.

As oil prices recover, sentiment toward emerging and frontier markets has improved, said Chakrabortty, and investors have increased their risk exposure.

Emerging-markets stocks tend to receive international fund flows first as “emerging markets are easier to access than frontier markets,” said Gabriel Sacks, an investment manager.

“Now you are starting to see a pick up in investment flows into frontier markets.”

Currency is also an issue as it is related to liquidity when investing in these smaller markets. Some frontier countries have their currencies pegged or managed. This requires large amounts of reserves for the country’s government, or central bank, to constantly buy or sell the domestic currency, adding pressure to the country’s financial stability.

Investors would rather put their money to work in more liberal capital markets as they would not want to run the risk of having their money confiscated by government authorities.

Egypt and Nigeria are cases in point. Both markets had their currencies pegged but due to financial hardship had to go through devaluations in 2016—and in Nigeria, investors endured a “painful period” where they could not withdraw their money due to restrictions on foreign currency trading, Sacks said.

Pros: Growth, Yields, Valuations
And yet, portfolio managers of many emerging-markets funds dabble in frontier markets.

“I do think frontier markets are worth the effort,” said James Donald, a portfolio manager in New York.

“We have had frontier stocks in our emerging market portfolios for a large part of the last 20 years, and we have had them for years at a time.”

Donald warned that “from a risk point of view, you cannot go in extremely deep because liquidity is typically not that high, but there are some great investment cases.”

The rapid pace of growth, higher dividend yields, and cheap valuations make the asset class enticing to long-term investors willing to do the shoe-leather work.

“Many companies in frontier markets have grown their earnings by 10% to 15% a year, yet we are seeing an index that is still in the same valuations,” said Fletcher.

The underlying earnings growth of companies in frontier economies has outperformed those of emerging countries, experts say.

“Companies in frontier markets have higher returns, with higher ROEs, and profit margins have been 1.5 times that of average emerging-market companies,” said Chakrabortty.

Dividend yields in frontier markets are at 4.2% compared to 2.5% for emerging markets.

Emerging-markets funds tend to have exposure to frontier market companies across regions. Argentina, Saudi Arabia, Vietnam, Bangladesh, Morocco, and emerging Europe are sources of growth, investors say.
Yet money managers generally have a “bottom-up” approach to investing in this asset class.

“We tend to take a company-specific approach when evaluating those opportunities,” said Timothy Morris, a client portfolio manager in New York.

“That includes the broader environment the company is operating in, the stability from a geopolitical perspective, and also what type of influence the government might have on the opportunity. Those are risks inherent in all emerging-market investing, and they might be more pronounced in frontier markets,” Morris added.

Investing Ideas
Investors looking to get exposure to frontier market companies will likely find that broad emerging-markets funds already provide some exposure to this relatively new asset class.

 

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