Frontier Markets: The New Emerging Markets?

By Jessica Lin, Matthew Rosen and Karl C. Mergenthaler, CFA
jessica.c.lin@jpmorgan.com, matthew.rosen@jpmorgan.com and karl.c.mergenthaler@jpmorgan.com

Frontier markets, or "pre-emerging" markets, have recently been gaining attention from investors worldwide. While these markets are still in their early stages of development, some investors consider them an attractive opportunity for long-term economic growth with strong return potential. This high growth potential is, however, accompanied by greater risk and inefficiencies which are inherent in the young economies of these frontier markets.

Following the rapid growth and development of emerging markets in the late 20th century, frontier markets may be at a stage where similar investment opportunities are available. Frontier markets are often characterized as being highly volatile, risky, and inefficient, but recent improvements and conditions have made it easier to invest in these previously overlooked markets. However, many investors argue that the risks and illiquidity of these investments may outweigh any potential returns.

Background

The concept of frontier markets was initiated by the International Finance Corporation ("IFC") in the early 1990s. Subsequently, Standard & Poor's bought IFC's Emerging Markets Database and established the Select Frontier Index in 2007. Although there is no single definition for what qualifies as a frontier market, the term refers to small and/or unstable countries in which the equity markets are investable but do not have the market capitalization, liquidity, or other market attributes of more mature emerging markets. This category includes a large and diverse range of countries such as Nigeria, Vietnam, Slovenia and Panama.

In recent years, MSCI, Russell, and FTSE have each established frontier market indices. MSCI's Frontier Markets Index consists of 25 countries while Russell's index contains 39 countries. In order to select countries within the Frontier Markets Index, MSCI uses three criteria to determine market classification: economic development, size and liquidity, and market accessibility. The Russell Frontier Index includes countries that are not yet considered emerging markets based on market capitalization, risk, and liquidity prerequisites but have accessible market data available. Russell limits any one country weight in the mix to 15% in order to minimize single-country risk and distribute exposure in a more regional manner. In Exhibit 1, we summarize the exposure of various frontier markets indices to global regions.

Exhibit 1: Exposure of indices to global regions as of 2011

Source: The Research Foundation of CFA Institute, MSCI, Russell, S&P

As Exhibit 1 indicates, the Middle East represents a significant portion of the broad frontier markets category. As such, each index tracks frontier markets both including and excluding the Gulf Cooperation Countries ("GCC").

The various index providers continuously review the categorization of an individual country as "frontier," "emerging," or "developed." For example, MSCI has demoted five countries from emerging market to frontier market status: Sri Lanka (2001), Venezuela (2006), Jordan (2009), Pakistan (2009) and Argentina (2009). Meanwhile, the largest frontier country, Qatar, is under consideration for an upgrade to emerging status.

Demographics suggest growth potential

Broadly, emerging and frontier markets are gaining a higher share of global GDP while developed countries' contributions are decreasing over time. According to The World Bank, in 2011 frontier markets saw an average GDP growth rate of 4.9% while the 10 largest advanced countries experienced only 1.6% growth.

There is a range of economic growth and potential within the frontier markets universe. Both Qatar and Argentina saw GDP grow much higher than the average of developed countries, 18.8% and 8.0% respectively. Frontier market countries also have much lower debt-to-GDP ratios than developed countries. For example, according to the International Monetary Fund (IMF), African nations' debt-to-GDP ratio has decreased from 60% in 2001 to 20% in 2011, while developed countries' debt-to- GDP ratio has risen from around 46% in 2007 to over 70% in 2011. The fiscal status of many frontier market countries has improved relative to that of developed market countries in recent years.

Another driving factor behind the high potential growth factor of frontier markets is its young labor force. The average age of the 2 billion people living in frontier market countries is 30.2 compared to 40.5 for the 1 billion living in developed countries.¹ The work force in frontier markets is not only larger and younger, but also much cheaper than in both developed and emerging market countries. This could provide many opportunities for political and economic growth.

At the same time, frontier markets may involve a significant amount of economic risk and uncertainty. The central risk that frontier market countries face is the increased volatility due to factors that plague developing countries, such as political unrest, business corruption, and reliance on a single-commodity. For example, although Nigeria has substantial oil reserves, development has been impeded by extremist takeovers and pipeline vandalism. Moreover, while some frontier market countries have great growth prospects, transparency is limited and may be insufficient for traditional investors.

Frontier markets may improve diversification of portfolios

Despite the economic and social risks, frontier market equities may mitigate investment risk by adding diversification to a portfolio. We analyzed historical performance data from June 2002 to April 2012 of four different indices and examined their correlation to the MSCI Frontier Markets Index. Our analysis suggests correlation between the four indices - MSCI All Country, MSCI EAFE, MSCI Emerging, and MSCI USA - are all very close, ranging from .82 to .98, meaning that these indices all move similarly to each other during typical market conditions. Meanwhile, the MSCI Frontier Index had a much lower correlation to the others, from .54 with the S&P 500 to .62 with the MSCI EAFE Index. However, frontier markets and developed markets are becoming more closely correlated, especially during volatile times. Correlation of MSCI Frontier and S&P 500 was .72 in the past five years compared with .54 during the span of 2002- 2012.

On a valuation basis, frontier markets do not appear to be expensive. In Exhibit 2, we summarize the Price to Earnings and Price to Book multiples of the MSCI EAFE, MSCI USA, MSCI Emerging Markets, and MSCI Frontier Markets indices as of June 2012.

Exhibit 2: Comparing P/E and P/B of different indices (June 2012)

As shown in Exhibit 2, frontier markets appear to be cheap relative to their developed and emerging market counterparts. We would note the P/E and P/B multiples for U.S. and emerging market equities are both slightly lower than their 10-year averages. Also, the valuation metrics for frontier markets may be somewhat unreliable as forward earnings projections are not readily available. Nonetheless, the valuation metrics for frontier markets do not reflect a particularly optimistic outlook for this segment of the global economy.

Active management may be appropriate

In our opinion, the inefficiency and illiquidity of frontier markets lends itself to active management. In recent years, at least 14 asset managers have initiated strategies in the frontier markets. As of the end of 2011, there was approximately $3.3 billion in assets under management in the frontier markets. For comparison, there were at least 67 asset managers with over $500 billion in assets under management in emerging markets strategies. Almost half of all frontier market managers use a fundamental investment methodology, which is consistent with emerging markets and developed equity managers, while the other half is split between quantitative and combined strategies.

In Exhibit 3, we examined the excess returns of managers within three different asset classes over their respective benchmarks: S&P 500, MSCI Emerging Markets, and MSCI Frontier Markets.

Exhibit 3: Excess returns 2005-2011

Source: eVestment Alliance, Bloomberg

As Exhibit 3 illustrates, active managers in the frontier markets performed extremely well relative to the benchmark in 2006 and 2009 but were far below their benchmark in 2005.

Within the frontier markets, there is a wide dispersion of performance between the individual countries. We analyzed the historical return performance of the countries within the major frontier market indices. In Exhibit 4, the blue columns represent the returns of the top quartile of frontier market countries in the MSCI Frontier Markets Index while the red columns represent the returns of the 25th percentile. As shown, there is a significant difference between the two groups, with the 75th percentile outperforming the 25th percentile by an average of 18% over the past five years.

Exhibit 4: MSCI Frontier Market Index returns - 75th percentile vs. 25th percentile

Source: MSCI

In our opinion, the ability to identify and invest in the strongest performing frontier markets can mean the difference between substantial returns and substantial losses; thus, demonstrating again the need for active management in this space.

Clearly, the nature of frontier markets requires more attention from investment managers; thus, management fees for this type of investing are much higher than that of more developed markets. As shown in Exhibit 5, average frontier market management fees are almost twice as high as U.S. Large Cap Equity fees.

Exhibit 5: Management fees comparison 25th percentile

Source: Evestment Alliance

In addition to volatility and issues with governance, investors face the problem of liquidity within these markets, which is broadly defined as the ease at which securities can be bought, sold, and converted to cash quickly. Due to the lack of liquidity and ultimately efficiency within frontier markets, investors must be prepared to sell securities at a lower price because of lack of demand, experience higher than average failed trades, pay stiffer transaction costs, and deal with settlement issues. This, of course, depends on the continent an investor is trying to trade in. For example, trading in an African country is likely to be more difficult and costly than trading in Latin America simply because the trading volume in Africa is lower². In addition to a lack of liquidity, foreigners may face a barrier to entry in many frontier markets because of regulatory issues and currency restrictions. This has been evident in Lebanon, where foreigners still cannot hold local currency balances overnight. Thus, concerns over liquidity and regulations for foreign investor are obstacles that one should consider when deciding whether or not to invest in frontier markets.

As frontier markets continue to develop, relatively high rates of inflation may also present additional risk. The average inflation rate of MSCI frontier market countries is 6% compared to 3.8% in MSCI emerging markets and 2.9% in MSCI developed markets (ex. U.S.). Consider Bangladesh, where inflation in 2012 has been 9.15% and the YTD return -15.59%. The existence or threat of hyper-inflation must be considered by active investors in the frontier markets.

Conclusion

In our view, frontier markets pose a complex series of investment questions and issues. The table in Exhibit 6 summarizes some of the key pros and cons to investment in the frontier markets.

Exhibit 2: Comparing P/E and P/B of different indices (June 2012)

Bullish investors may argue that demographics and economic growth potential provide a compelling long-term investment case. Moreover, frontier markets may offer a potential source of diversification in institutional portfolios.

On the contrary, skeptics may suggest that the plethora of social and economic risks, as well as the illiquidity, provide ample reason to stay on the sidelines.

¹IMF, World Economic Outlook Database
²Frontier Markets – CFA Institute