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Frontier Markets For Dummies
By Al Emid, Gavin Graham
John Wiley & SonsCopyright © 2014 John Wiley & Sons, Ltd
All rights reserved.
Forging into New Investment Frontiers
In This Chapter
* Getting to know Frontier Markets
* Reviewing special issues in Frontier Markets
* Adding Frontier Markets to your portfolio
* Investing wisely
Let's lay some groundwork here!
We consider Frontier Markets a subset of Emerging Markets that offers you, the investor, the opportunity to make returns similar to those delivered by the major Emerging Markets over the decade ending December 31, 2012. At that time, the MSCI Emerging Markets Index returned 13.7 percent per annum, more than doubling an investor's initial investment, depending on date of deposit.
Comprised of countries ranging from the large, young, and fast-growing nations of South Asia and sub-Saharan Africa to the middle-income and middle-aged group of South American and Eastern European states to the small, wealthy emirates and nations of the Persian Gulf, the 41 frontier economies in the MSCI and S&P Frontier Markets Indices make up 14 percent of global population and 7 percent of global gross domestic product (GDP) on a purchasing power parity (PPP) basis.
Including those Frontier Markets with barriers to entry due to lack of liquidity or restrictions on foreign investment brings these totals to 25 percent of global population and 11 percent of global GDP.
Acquainting Yourself with Frontier Markets
Frontier Markets are less-developed economies not included in either the MSCI World Index of developed countries or the MSCI Emerging Markets Index. That index includes 21 emerging economies, including the largest and best known, the BRICs, comprised of Brazil, Russia, India, and China.
While the established Emerging Markets comprise almost two-thirds of the global population and one-third of global stock market capitalization, Frontier Markets make up less than 2 percent of global stock market capitalization. With those basic definitions in mind, the rest of what we suggest may make more sense to you.
As another quick definition, market capitalization refers to the total value of equities available for public trading, whether referring to the total for a specific corporation or country's stock market.
With Frontier Markets, this means that their capitalization-to-GDP ratio is extremely low (2 percent against 11 percent). Because they include some of the world's fastest-growing economies, including six sub-Saharan Africa countries, their stock market capitalization should grow just to reflect their growing GDPs.
Moreover, we believe that, in a fashion similar to what occurred with Emerging Markets over the last 15 years, the valuations that investors will pay for the growth in Frontier Markets will rise as well. That would give early investors putting money into these markets in the next couple of years the strong probability of excellent returns. Still, those same investors will need strong nerves to absorb the volatility of Frontier Markets and to adjust to their lack of familiarity. However, we suggest to you that by investing in an actively managed global Frontier Markets fund, investors give themselves the best chance of succeeding.
What qualifies as a "Frontier" Market
There are no firm guidelines as to what constitutes a Frontier Market. On July 1 of each year, the World Bank divides countries into four categories, based on annual gross national income (GNI) per capita on a purchasing power parity (PPP) basis. The four categories on July 1, 2012, were:
[check] Low income: Below US$1,025
[check] Lower-middle income: US$1,026–$4,035
[check] Upper-middle income: US$4,036–$12,475
[check] High income: Above US$12,476
The World Bank notes that low- and middle-income countries are often referred to as "developing economies," but goes on to note that although the term is convenient, it does not imply that all countries in the categories have reached a similar stage of development.
While Emerging Markets are essentially all countries whose GNI is below US$12,476, Emerging Market indices also include some countries with higher GNIs or GDPs per capita, such as Chile, South Korea, and Turkey. These countries are also members of the Organization of Economic Development (OECD), which is regarded as peopled by developed economies.
Frontier Markets, a term first used by the head of the International Finance Corporation's Emerging Markets database in 1992, are Emerging Markets that have lower market capitalization and liquidity than the established Emerging Markets or more restrictions on investment, or both limitations. While most Frontier Markets' GNI figures per capita rank in the low or lower-middle income categories, they include a number of wealthy countries that lack sufficient liquidity or have restrictions on investment that exclude them from the major emerging indices. These traits make Frontier Markets in general unsuitable for inclusion in the larger market indices, but they share many of the same attractive characteristics as the longer-established developing markets.
The nations and regions populating this sector
The MSCI and S&P Frontier Market indices, which are the most widely followed among investors, include the following 41 countries:
[check] Burkina Faso
[check] Ivory Coast
[check] Sri Lanka
[check] Trinidad and Tobago
Middle East and North Africa (MENA)
[check] United Arab Emirates (UAE)
Morocco was added to the Frontier Markets index by MSCI in November 2013. Qatar and the United Arab Emirates will be upgraded from Frontier to Emerging Market status by MSCI in May 2014.
Although this list appears fairly extensive, a number of quite large countries — either by population or by market capitalization — are excluded from these indices and are regarded as "Exotic Frontier Markets." These include Saudi Arabia, Iran, and Iraq in the Middle East, Cambodia, Laos, and Myanmar (Burma) in Asia, and numerous African economies, some with large populations, such as Ethiopia and the Democratic Republic of the Congo (DRC).
As the examples of Morocco and Qatar and the UAE demonstrate, the index providers change classifications with changing conditions. Indeed it is reasonable to assume that they may upgrade a number of Frontier Markets to Emerging Market status as their market capitalizations and liquidity grow. Similarly, Exotic Frontier Markets may graduate to full Frontier Market status. Countries with severe economic problems may find themselves going the other way, as happened to Argentina when it was downgraded to Frontier Market status in 2009 and Greece when it fell from developed to Emerging Market status in November 2013.
The risks in these markets
A number of Frontier Market companies have American Depositary Receipts (ADRs) trading on American exchanges and Global Depositary Receipts (GDRs) listed in London or Luxembourg, and therefore have to conform to the high standards of reporting and accounting in those countries. This reassurance does not alter the fact that these are highly volatile markets with a higher level of political and economic risk attached.
In the Financial Crisis of 2008–2009, the MSCI Frontier Markets Index fell 55 percent, even more than the MSCI Emerging Markets Index or S&P 500 indices. While the MSCI Frontier Markets Index was less volatile than the MSCI Emerging Markets Index over the five years including the financial crisis ending August 2012, it was much more volatile than the S&P 500 or the MSCI World Index of developed markets.
Furthermore, the Frontier Markets did not rebound as rapidly as the Emerging Markets, only regaining their 2008 high point in late 2013, compared with 2012 for the Emerging Markets. This provided investors with a benefit since it meant that Frontier Markets' valuations fell to low levels, making them good values compared to developed and Emerging Market valuations.
Why the average investor is stepping into these markets
First, it may be a mistake to refer to "the average investor," but you know what we mean!
Despite the high volatility and perceived level of risk in Frontier Markets, investors in North America and Europe are showing increasing interest. The Templeton Frontier Markets Fund, the oldest American retail frontier mutual fund, was launched in the United States and Europe in 2008 and Canada in 2011. It closed to new investors at the end of June 2013, as assets under management had exceeded US$3 billion, with over US$500 million being invested in the first half of 2013. The closing meant that the assets would not grow too rapidly, which meant that managers could continue investing in the same style as long as the inflows did not continue at the same rate.
Several new global and regional Frontier Market funds were launched in the United Kingdom and Europe during the year before we wrote this book, and institutions are beginning to allocate small percentages of their Emerging Markets portfolios to these countries.
This display of interest resulted from several factors, starting with appreciation in Frontier Markets. They have risen 20 percent in the last year while Emerging Markets indices have been flat or down.
Moreover, there is increasing recognition of the higher level of GDP growth Frontier Markets are enjoying compared to the maturing Emerging Markets, with Brazil's GDP growth in 2012 falling to only 1 percent and India's GDP growth for 2012–2013 forecast to fall to 4 percent, its lowest for a decade. Even China's GDP growth fell to 7.6 percent in 2012, well down on the 11.5 percent average rate it had attained between 2006 and 2011.
Investors have become more informed about the lack of correlation between the Frontier Markets and developed and Emerging Markets. Because of their small size and lack of liquidity, Frontier Markets do not move in line with the more liquid and larger developed or Emerging Markets. They have a correlation of less than 0.3 over the last decade with the MSCI World Index and 0.4 with the MSCI Emerging Markets Index.
A correlation of 1.0 means that two indices move perfectly in line with each other.
As a result, investors are becoming increasingly aware that adding a small percentage of Frontier Markets to portfolios reduces volatility. Even though they are volatile individually, they are not correlated with each other particularly. What happens in Estonia has little effect in Nigeria or in Bangladesh.
Identifying Special Issues Affecting Frontier Market Volatility
There are several issues that, while not peculiar to Frontier Markets, tend to have a greater effect on them due to their lower liquidity and less transparent reporting and accounting. While many Frontier Markets companies are well run and have good corporate standards of corporate governance, especially the locally listed subsidiaries of multinational corporations, the less-developed nature of institutions in developing countries results in non-financial factors playing a major role in how markets behave.
The influence of political systems
While most readers of this book live in a prosperous developed world democracy, many Frontier Markets have not yet moved to allowing their citizens to choose their government. You need to consider the different types of political systems when deciding where to invest your hard-earned dollars.
A number of kingdoms and emirates still exist in the Middle East and North Africa, ruled by third- or fourth-generation rulers. Among the monarchies in the MSCI Frontier Markets Index are:
[check] Saudi Arabia
[check] United Arab Emirates (UAE)
These countries are generally wealthy due to oil and other natural resources. With the exception of Morocco and Saudi Arabia, they are small in population and size. Their wealth and competent governments have kept them relatively secure during the unrest that swept the Middle East and North Africa after the Arab Spring began in 2011. However, there were riots in Bahrain, suppressed by the authorities. Historically, Middle East monarchies have proved vulnerable, with the overthrow of rulers in Egypt, Iraq, Libya, and Iran between 1952 and 1979.
Communist and autocratic regimes
The following Frontier Market countries have Communist or autocratic governments:
Although officially Communist, Vietnam, like China, has adopted capitalism under state oversight. That means that its economy has expanded substantially over the two decades since its opening, or Doi Moi. Laos has begun the same process in a limited fashion, with its stock market only having two listed companies at the time of writing.
Myanmar, formerly known as Burma, has been isolated under its military junta for most of the last 50 years and has become one of the poorest countries in the world. Its recent relaxation of controls, including the release of Nobel Prize winner Aung Sang Suu Kyi from house arrest and permitting opposition parties to win seats in parliament, may indirectly signal a willingness to permit economic reforms.
Kazakhstan, despite being a former Communist state, has developed a vibrant stock market and listed a number of its major companies on the London Stock Exchange. An autocratic regime, Communist or not, is not necessarily a negative when considering it as an investment destination.
In numbers too numerous to list, Frontier Market democracies range from the very large poorer countries of Africa and South Asia, such as Nigeria, Kenya, Pakistan, and Bangladesh, to some very small European states. They also include middle income Latin American countries like Colombia and Peru and small, relatively wealthy African states such as Namibia and Botswana. Additionally, the list includes East European former satellites of the Soviet Union, like Estonia, Slovakia, and Croatia, as well as middle-income countries like Bulgaria, Romania, and Ukraine.
East European countries that want to join the European Union tend to be more vigorous about protecting democratic rights, as this is a condition of membership. Nonetheless, the rise of democratic governments in Latin America and Africa over the last two decades has been one of the more exciting Frontier Markets developments. There tends to be a correlation between higher GDPs per capita and democracy, if only because removing a corrupt or incompetent government is much easier and less painful.
The scope of corruption and income disparity
Among the information that we include in this book is a chapter on corruption and income disparity, or the difference between the wealthiest and poorest sections of society. The perception by most foreign investors is that poorer countries are more corrupt, and we clarify this by using the Corruptions Perceptions Index produced by Transparency International. It asks international businesses how difficult or easy it is to do business in different countries.
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