Although funds that invest in so-called frontier markets are an appealing way to increase assets under management given strong investor demand, these markets pose numerous risk management challenges.
Why so much interest in frontier markets?
Variously described as "emerging-emerging," "next-generation emerging," "next eleven (N-11)" and "frontier," emerging and proto-emerging markets beneath the top two tiers of markets are in the spotlight for asset managers. According to data provider EPFR Global, investors put US$2.6b into dedicated frontier funds in 2010.
Relatively robust economic growth, impressive stock-market performance and increasing investor appetite for exposure to emerging markets such as Vietnam, Bangladesh and Pakistan are among the key reasons why managers are launching stand-alone frontier funds or allocating more assets to frontier markets within an existing emerging-markets strategy.
The lure of frontier markets
In the second quarter of 2010, China supplanted Japan as the world’s second-largest economy. Many analysts forecast that the size of China’s economy will surpass the US within two decades. The global economy is reconfiguring, and frontier markets comprise part of this reconfiguration.
Sustained demand from China, India and other rapidly growing economies for commodities and other products have bolstered the prospects of frontier markets - turning the deficits of the last decade into today’s surpluses.
Drivers of frontier economic growth
The drivers of frontier economic growth fall into three broad categories:
1) Growing populations
Vietnam, Bangladesh and Pakistan, for example, have fast-growing, younger populations that are fuelling increasingly competitive labor forces. They are benefitting from the so-called demographic dividend as the rising proportion of working-age people in the population helps to sustain economic growth.
2) Natural resources
Meanwhile, Kenya, Nigeria and Ghana have younger populations alongside plentiful agricultural and natural resources. For some other frontier countries, notably Qatar, Bahrain and Kuwait, natural resources are the main economic driver.
3) Economic growth
According to a recent International Monetary Fund (IMF) analysis, average real GDP growth among frontier markets in 2008 was approximately 4.8%, compared to 1.5% in the early 1990s. Urbanization and the growth of the middle-class are evident in many of these countries.
It is important to underscore that in many frontier markets, domestic consumer spending and infrastructure investment are also significant drivers of economic growth. In many frontier markets today, economic, fiscal and monetary policies are more supportive of sustainable growth than was typically the case a decade or two ago.
Government debt markets are growing, and some frontier markets now support relatively well functioning stock markets with frequent IPO activity (although they remain small in terms of total capitalization).
According to the World Bank, the 2009 median stock-market capitalization of frontier markets was just under 20% of GDP; the figures for emerging and developed markets were above 40% and 50%, respectively.
Valuations of frontier markets
Typical valuations of many frontier market stocks in recent years have tended to be lower in terms of price-to-earnings than comparable stocks in developed markets, or indeed top-tier emerging markets. It is no surprise that typical frontier market stocks are in the micro-/small-/mid-cap range.
The financial and telecommunications sectors account for the largest frontier sector exposures within broad indexes such as the S&P Extended Frontier 150. Although a number of frontier economies are dominated by large energy companies, some of these companies are unlisted or still government owned.
And with many frontier market currencies appreciating against the US dollar, investing in local currencies also presents the potential for higher returns.
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