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Five reasons to buy a frontier markets fund

Frontier markets have grown in popularity over the past year with many investors using them as an alternative to underperforming emerging market funds.

However, it is a part of the global equity market that carries with it a high degree of risk. Not only can frontier markets be illiquid, but they can also be prone to social and geo-political tensions; as shown by the recent crisis in the Ukraine and uprisings in the Arab World before that.

We asked fund managers for five key reasons investors should buy into frontier market funds now.

1. They are growing rapidly

While it may sound obvious, Allan Conway – head of global emerging markets at Schroder and manager of the Schroder ISF Frontier Markets Equity fund – says investors shouldn’t forget that frontier markets offer strong growth potential.

“Frontier markets offer much stronger growth relative to developed and emerging markets,” Conway (pictured) said.

“We know that the growth outlook for developed markets is expected to be relatively low and emerging markets should still be growing around 3 per cent per annum faster. However, frontier markets should grow 3 per cent per annum faster than that.”

“While there is no direct long term correlation between GDP growth and stock market performance, when economies go through periods of rapid growth their equity markets have always tended to perform well.”

2. They are diversified

Conway says that another reason why frontier markets are attractive is because there are a range of different economies, which have different economic drivers, within the index.

“Another point I would make is that they have a competitive advantage,” Conway said.

“There are two types of frontier markets. The first are the economies with young and growing population, which are the low cost producers. For instance, labour costs in China are 10 per cent lower than in the US. However, Bangladesh’s labour costs are 10 per cent lower than in China.”

Apart from Bangladesh, Conway would also put the likes of Vietnam and Sri Lanka into the bracket of a young large population that offers cheap labour.

The other group of frontier markets, according to Conway, are the natural resources economies such as Kazakhstan and Nigeria.

3. They have performed well, but are still fairly priced

While emerging markets such as the BRIC nations have performed poorly relative to the likes of the US and UK over recent years, frontier markets have generated a decent level of return.

According to FE Analytics, the MSCI Frontier Markets index has returned close to 20 per cent last 12 months, while the MSCI AC World index has returned 5.76 per cent and the MSCI Emerging Markets index has lost more than 7 per cent.

Performance of indices over 1yr

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However Premier’s Simon Evan-Cook. who uses frontier market portfolios within his fund of funds, says that they are still attractively valued despite the recent period of strong performance.

“They have come off a very low base,” Evan-Cook said.

“If you were to look back to the “Arab Spring” in 2011 – with many of those Arab countries featuring in the index – there was a significant sell-off. That means that while they have performed well, it started on the back of very low valuations.”

“I think valuations are very reasonable, especially as the large majority of companies within the index are exposed to their own countries’ growth – which is very fast – not the global economy.”

4. Hot money can’t touch them

One of the major reasons why Evan-Cook favours frontier markets is because they are not affected by huge amounts of inflows and outflows from exchange traded funds (ETF) because it is a relatively illiquid asset class.

“There is possible one or two frontier market ETFs, but it isn’t tracked anywhere near to the extent of emerging and developed markets, which means they aren’t at the mercy of hot money” Evan-Cook said.

“It is much more about local investors investing in local companies as there isn’t the liquidity for big international investors to gain exposure. That takes a lot of macro risk out of the equation, as they won’t be hit by ETF outflows if global risk sentiment were to turn.”

For instance, Evan-Cook attributes the recent underperformance of some of the larger emerging market funds, such as portfolios run by Aberdeen and First State, to huge outflows from ETFs which in turn caused the share prices’ of the largest constituents of the index to plummet.

5. They are uncorrelated to global markets

The final point that both Evan-Cook and Conway make is that the drivers of frontier markets performance are independent to those of the developed and emerging markets.

“From a risk management point of view, they can help a portfolio’s diversification characteristics,” Conway said.

“They aren’t affected by the Fed will do next in terms of tapering or slower Chinese growth. They are relatively uncorrelated to both emerging and developed markets.”

For instance, global equity markets nose-dived in May last year when Ben Bernanke, chairman of the US Federal Reserve, warned the market that he would look to taper quantitative easing.

Emerging markets, which had been one of the major beneficiaries of the added stimulus, were particularly affect by the announcement.

However, the MSCI Frontier Markets index carried on performing well.

Performance of indices between May 2013 and June 2013

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However, Evan-Cook says that this can work the other way, such as during Arab Spring in 2011.

“Frontier markets are uncorrelated to other parts of the world, which we have seen over the last few years, for better and worse,” he said.