How to invest in the 'star economies' of the future

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Frontier markets - the smaller, less well-established, highly risky but often extremely dynamic economies - are a fascinating investment story.

Individually, these countries may be politically unstable, economically imbalanced or relatively inaccessible to foreign investors.

But frontier market funds that invest across a number of highly diverse markets can be markedly less risky. They can also be very rewarding.

Here, we look at the rationale behind investing in frontier markets, and prospects for these funds against a highly uncertain backdrop in 2017.

The best and worst performing stock markets in 2016

UNDERLYING LIQUIDITY ISSUES

'The financial crisis is a good place to start with frontier markets, as what happened there really exposed the risks of the asset class,' says Adrian Lowcock, investment director at Architas.

He explains that frontier markets are underdeveloped and very small when compared to the UK or US markets, or even to many more established emerging markets, which means there is not as much liquidity in the underlying investments.

The financial crisis hit frontier markets hard, because investors rushed to sell their riskiest assets and the lack of liquidity meant share prices fell much further.

The lack of efficient and well-regulated markets also contributed to the issues, with many frontier markets freezing up at the height of the financial crisis.

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The subsequent recovery has been much slower than in developed and even emerging markets, Lowcock says.

'Investors' appetite for risk has not been quite the same since, and frontier markets are not the normal hunting grounds for income-seekers. The interest in frontier markets has taken a long time to return; as with emerging markets, the sector has not been in vogue.'

CURRENCY MOVEMENTS

He adds, however, that currency movements play a major part in returns, and that the weaker pound has helped UK investors recoup some of the drop in performance.

Frontier markets are those economies around the world that have yet to become stable; they may lack standard legal and financial regulatory institutions, and are therefore riskier environments for investors.

But the attraction of frontier markets has been and continues to be their low levels of correlation with each other, as well as between them and emerging and developed markets, says Sam Vecht, manager of the BlackRock Frontiers trust.

'Frontier markets look an awful lot like emerging markets did 20 years ago,' says Andrew Lister, senior investment manager at Aberdeen.

He adds that some of the positive effects of globalisation, increasing consumption and population growth that have driven emerging markets forward are set to boost frontier markets too.

However, frontier markets don't necessarily transition to become emerging markets. Some countries oscillate between stages of development.

Lister explains that Argentina, for instance, is considered a frontier market at the moment, though it was emerging five to six years ago and developed at the time of the Second World War.

It was accorded frontier status in recent years 'due to its politics and the knock-on effect of inaccessibility to the market'.

Lister suggests that in practice Argentina has a frontier stock market but a middle-class economy, high GDP per capita, a good infrastructure, and it is set to become emerging again.

Another example is Saudi Arabia, which is not easily accessible to foreign investors and is therefore not currently formally classified as a frontier market.

But once that changes, says Lister, it could rapidly leapfrog the frontier stage and gain emerging market status due to its size and the market's liquidity.

UNDERVALUED STOCK MARKETS

Michael Levy, co-head for emerging and frontier equities at Barings, emphasises that frontier markets are incredibly diverse.

Pakistan is very different from Vietnam or Saudi Arabia; they're not comparable politically, or even in terms of the composition of companies. That also means low correlation with other markets.

The sector includes countries in the Balkans, Asia and African countries, says Lister. 'They are less understood, so there is more opportunity - they have some of the most undervalued stock markets in the world.'

But while frontier markets are usually considered risky, Lister says: 'If 2016 taught us anything, it's that political risk is a universal phenomenon.'

From the period between the UK referendum in June last year and the US presidential elections in November, frontier markets showed a remarkable degree of resiliency given increased levels of uncertainty, due to their lower correlations with the developed world, says Vecht.

He argues that frontier market economies remain relatively closed off, because they have limited economic links to the rest of the world.

But meanwhile their political governance is improving, their cash flows are growing, valuations are cheap and they also continue to offer above-average yields.

These qualities have made frontier markets such as Pakistan and Bangladesh a valuable diversifier in 2016, and he suggests they will continue to be important this year. But, of course, each frontier market region poses its own political and economic risks.

Over the past 10 years, different frontier economies have been affected by, for example, the Arab Spring, the global financial crisis, political change in Argentina, Kenya and Nigeria, the Russian invasion of Crimea, oil prices halving and commodity prices collapsing.

But Lister adds that there's always someone who's a beneficiary too. His favourite markets at the moment are in Asia, particularly Pakistan and Vietnam.

He also likes Romania in Eastern Europe, where 'the economy is doing well but the stock market is not doing as well as those Asian markets'.

COMPELLING COMBINATION

Markets such as Argentina and Bangladesh, meanwhile, present a 'compelling combination of the countries with the fastest-growing GDP, the best demographic profiles, the lowest government debt and a substantial commodity endowment', according to Vecht.

'It is also possible to find companies with strong cash flow and high dividend yields, on some of the lowest valuations in the world.'

Frontier markets tend to be underresearched, which gives active managers the opportunity to outperform.

The trust Vecht manages has so far had a large weighting in South Asia, particularly in Pakistan, Bangladesh and Sri Lanka, but as companies' shares in these regions are becoming more expensive, he says that 2017 might see a move away from those areas, possibly towards the Middle East, Africa, Vietnam or Latin America.

'The past 12 months have continued to demonstrate the benefits of investing in this wide, diverse asset class.

'In most countries domestic, economic and political developments drove market returns, and we expect Argentina to be one of the strongest performers during the year,' says Vecht.

Levy too is positive on the frontier market outlook. He argues that while 2016 was a tough year because of the impact of the low oil price, the commodity backdrop is more stable this year. But it is arguably only natural for fund managers to be positive on their own asset class.

Lowcock, however, argues that for frontier markets to perform there needs to be a strong, positive outlook for the global economy; whilst sentiment has improved over the past 12 months, 'there are still many risks to global growth and investors are generally remaining quite cautious'.

Frontier markets are always going to face these big challenges, and arguably the case for investing in them is never going to be perfect, Lowcock concludes. He emphasises that investors considering the sector need to think very long term, at least 20 years.

'These markets are likely to be very volatile and investors should view them as an asset class where they could lose their initial investment.

'I would only suggest having a small amount in this area - 1 or 2 per cent at the most - and even then only for adventurous investors with larger portfolios.'

PROS AND CONS OF A PASSIVE APPROACH

Exchange traded funds (ETFs) track the stock markets of a group of frontier economies; they give investors access to the whole market or a sector of it, and therefore more diversification.

It is often difficult to know which country or sector will be the best performer in any given year, and an ETF covers all bases.

ETFs are also cheap compared to active managers in the frontier market arena, as a lot of research is involved to find hidden gems.

The cheapest ways to track global stock markets

Lowcock says: 'I would suggest Dbx-trackers' ETF, which is London-listed. It reflects the performance of the S&P Select Frontier Index, which comprises the shares of 40 of the largest and most liquid companies from the S&P Extended Frontier 150.'

Against this, active managers can add much value in frontier markets, as they may be able to sniff out undiscovered bargains.

In addition, says Lowcock, 'good active managers should be able to avoid the riskiest businesses and those countries where there are regulatory issues or poor corporate governance. At the same time they should be able to spot the best businesses to deliver stronger growth for investors'.


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