An Introduction to Frontier Markets
In recent years, the investment management industry has come under scrutiny for not delivering adequate value for money. The Financial Conduct Authority (FCA) introduced rules on the disclosure of costs and charges in 2019 on top of those under EU MiFID II and PRIIPS. These regulations have driven competition and accelerated the shift towards lower-cost passive investments.
The industry is constantly changing, finding new ways to achieve Alpha (an investment strategy’s ability to beat the market) and providing better value for money for its clients. The rise of alternative asset classes has contributed positively to this aim. However, active managers have struggled to outperform developed markets (especially the US) in recent years, because of the market’s high efficiency: information spreads quickly and prices respond rapidly to them. This has led many active managers who have the commitment, skill, and global resources necessary, attempting to take advantage of the market efficiencies found in frontier markets.
Persistent risk and hurdles plague frontier markets, and therefore these markets are at the edge of acceptable investment horizons. However, talented managers have gained from the high profits and growth potential of frontier markets.
Fund managers are aware of the concept that they cannot separate excessive returns from the possibility of higher risks, and frontier markets fully embody this concept. But why are some fund managers confident that frontier markets are worth this risk?
Understanding the Market
Frontier markets are third in the investing hierarchy. Ahead of them are developed and emerging markets, and below are standalone markets. Market classifications are not focused on a country’s wealth but on the stage of development of their capital markets. The criteria for market classification focus on openness to foreign ownership and the ease of capital flows. The MSCI, the world’s biggest index compiler, requires that the country have at least two companies worth $700 million each.
Under the World bank’s developed/developing country taxonomy, some countries in frontier markets would be categorized in the same group as many countries in emerging markets. However, with the financial markets, the market value is key. Frontier markets have a significantly smaller market value ($715 billion) compared to emerging markets worth around $20 trillion.
Frontier markets exhibit a large degree of inefficiency primarily because of the capital markets being in the early stage of development. The lack of transparency causes information asymmetry, and this results in a wide disparity between a company’s value and potential for growth and its current share price. Whilst this poses a significant risk to portfolios, there is also the potential for investors to gain considerable returns.
The macro conditions of frontier markets also pose a significant risk for investors. Investors will take risks in regions where corruption is rampant, as well as regions facing civil unrest and war. This will mean that even well-researched, high-quality stocks can underperform significantly in any given year. However, in an article for the CFA Institute, Larry Speidell, CFA, states that ‘inefficiency equals opportunity’. Frontier markets are known to offer attractive risk-adjusted returns and have a low correlation to developed markets.
Many frontier markets have favourable economies. With a young labour force, low wages and increasing productivity, many of these economies are in a good position for economic prosperity. Countries in frontier markets are also seeing an improvement politically with the support of the World Bank and international communities. As frontier markets continue to grow, contrarian investors who have been persistent and diligent in the allocation of capital in these markets will benefit from its growth.
The comparably small market value might dissuade many investors. However, active managers who believe they can systematically capture the alpha opportunities in this market are taking advantage of the market inefficiencies. The opportunity to get into the market before the crowd attracts many active managers. As the economy prospers, investors will benefit from outsized growth as investors pour in at a later stage. Pakistan stock exchange (PSX) is a perfect example. PSX recovered 40% over the last 11 months, reached all-time high trading volumes, and was promoted by the MSCI to emerging-market status. Frontier markets, like any investment with huge potential returns, have even bigger risks. Although many global markets slumped during the heights of the pandemic, some frontier markets soared. Argentina’s flagship index grew by 23% in local terms by the end of 2020. The Iceland OMX rose by 25% in the same period, and the Nigeria all share index was ranked as the best frontier market in 2020 and the highest performing market in the world. The market ended the year with just over 50% and seven stocks posted gains of over 100%. In the same year, the MSCI Frontier markets Index posted a return of -2.41%, therefore when investing in such markets, it is crucial to pick the right market at the right time.