Investors seek fortune in frontier markets

Long-term potential makes them attractive As a group, it couldn't get more diverse and far-flung — from Sri Lanka and Vietnam to Nigeria and Zimbabwe, from Ukraine and Kazakhstan to Argentina and Trinidad and Tobago and from Croatia and Bulgaria to the UAE and Lebanon.

These are some of the countries, among several others, that comprise the frontier market category, and are no more unknown, untreaded territory for investors. The performance of selected frontier markets in the recent past with the long-term potential that could make them the next set of emerging markets are attracting investors from all across the world. The two-year, through March 31, 2011, annualised return, for example, of MSCI Sri Lanka, Ukraine and Argentina was 106.92 per cent, 74.84 per cent and 73.61 per cent respectively. Over the same period the MSCI Frontier index comprising all frontier stock markets, some of which had negative returns, had an annualised return of 26.11 per cent. "In the case of our frontier fund, it's 80 per cent foreign [non-American]. We are now getting investors from Europe, Latin America, Asia, so forth," said Mark Mobius, executive chairman, Templeton Investments Emerging Markets Group, during his recent visit to Dubai. The Templeton Frontier Markets Fund was launched in October 2008.

Rami Sidani, head of Middle East and North Africa Investments at Schroder Investment Management, agreed and pointed to one more benefit to international investors.
With the global macro-economic environment still dominated by uncertainties, such as sovereign debt risks in the Eurozone and the need for significant fiscal retrenchment in the US, he said frontier markets tend to exhibit low correlation with global markets, offering investors potential diversification benefits. "Yes, interest is growing around the world," Sidani said. "Initially it was from institutional clients but increasingly [we see interest] from a broader array of investors."

Schroder's Frontier Markets Equity is the newest entrant, having launched in December 2010. Both funds, domiclied in Luxembourg, are available to Gulf investors with a minimum investment of $5,000 (Dh18,500).
While Templeton's and Schroder's funds are dedicated to frontier markets, there are others such as European Frontier Fund managed by Aberdeen Asset Management (since 2009) which have smaller exposure to frontier markets like Slovenia and Kazakhstan. The frontier component is about 10 per cent, with majority of the fund invested in traditional emerging markets, such as Russia, Turkey, Hungary and Poland, according to James Thorneley, Group Communications Manager, Aberdeen Asset Management, London. The fund is marketed only in the UK.

For the veteran emerging markets investor Mobius it is like revisiting the past with an eye to the future. "In 1987 we started emerging markets fund and in those days everything was frontier because most markets were not open," he said. "A lot of people don't realise that we had few markets [at the time] to invest around the world. Five of those markets were in Asia and one was in Latin America, [that was] Mexico. Most of the markets around the world had exchange controls. In Latin America they had laws that prevented foreign investments," Mobius said.

Frontier funds are getting more adventurous venturing into some countries of Africa, eastern Europe and Asia, which are just starting to open up. Besides some of them being small, illiquid and volatile, there is the challenge of the custodial situation. The fund needs a custodian bank, which is a safe place to keep their securities and which also takes care of collecting dividends. In some countries, a delivery versus payment (DVP) settlement system is yet to be adopted. In the UAE, its implementation was delayed last week and is now expected to come into effect at the end of May. When deciding to get in, the funds also look for clear stock market regulations, what the barriers to entry are and whether foreign exchange controls are going to inhibit investments.Templeton's foray into the frontier territory two years ago is starting to bear fruit. Not just in terms of the growth in size of the funds, but also in terms of returns.

For the fund Templeton had $100 million to begin with and it's now worth up to $1.2 billion. The growth is the result of new money coming in and the increase in the value of the shares bought by the fund. The MSCI Frontier Index year-to-date through March is down -5.41 per cent whereas Templeton's Frontier Markets Fund A(acc) USD share class is down only -2.01 per cent. According to Dunny Moonesawmy, head of fund research, Western Europe, Middle East and Africa, the fund had 5.90 per cent return with a maximum drawdown over one year of 10.47 per cent. Drawdown, which is defined as the peak to trough decline during specific periods of investment, is a measure of risk. It must be kept in mind that while the current MSCI frontier market list consists of 26 countries, fund managers have invested in countries not on the list, but which they consider frontier. The Templeton Frontier Fund, for example, has invested in Saudi Arabia which was removed from the MSCI and S&P indices in 2010.

The Schroder's fund year-to-date through March is down year 5.60 per cent as against the 5.49 per cent of the MSCI Frontier index. During the turmoil in the region in late January and February, the Templeton fund witnessed net inflows, even though there was a slowdown. "Money was going out, but more money was coming in during the crisis, which again was surprising because you would expect people really running for the exits… People are now much more reluctant to run for the exit at the first sign of a problem. They begin to think twice because they realise these things blow over and there are opportunities to stay in," Mobius said. One of the main reasons behind the fund seeing greater inflow during the crisis is the fact that shareholders of the fund know how cheap the holdings are and how they are getting cheaper even now, said Dubai-based Ahmad Awny, vice-president, Franklin Templeton Investment Management. "They have seen that throughout the life of the fund. It happened 1-1/2 years ago, when the stocks were really, really cheap and the markets suffered from the credit crunch and people started selling the shares and we started buying more because that was a more lucrative opportunity to add to our positions," Awny said.

The Templeton fund's current exposure includes, among others, Nigeria, Vietnam, Egypt, the UAE, Kazakhstan, Ukraine, South Africa and Argentina. Egypt and South Africa fall under the emerging markets category, but because both have companies that have exposure to some of the frontier markets, Templeton includes them in both categories. As per their April strategy meeting Schroder's top investment markets were: Saudi Arabia, Qatar, Kazakhstan, Nigeria and UAE. They have no exposure to Egypt in the fund.

In terms of industry breakdown, both funds exhibit almost a similar pattern: financials/banks followed by telecommunication or industrials and energy exploration and production. "If you look at this breakdown and if you look at the emerging markets portfolio it's quite different, particularly in the area of telecom," said Mobius. "In our global funds we found that telecoms are relatively expensive whereas in frontier markets they are relatively cheap."
Talking about people redeeming from open-ended funds as theirs, Mobius added that's it's not much of a problem given the way markets are expanding. "In emerging markets last year, for example, including frontier markets, a total of $450 billion in new issues came in to the market, both in terms of IPOs and secondary issues."

Also, for Mobius, one word sums up the frontier market story: commodities. Because they are rich in all manner of natural resources and are leading producers of, among others, oil, gas, minerals and precious metals, many frontier market countries are well positioned to benefit from the strong demand for these resources from high-growth countries like China and India, he said.
"Demand for these resources boosts economic growth in frontier markets," he said, "which then enables their governments to increase spending in infrastructure, thereby creating interesting investment opportunities in the construction, transportation, banking, finance and telecommunications industries."

But while commodities may well be the engine of growth for frontier markets, Mobius is equally interested in the growth of consumer demand in these countries. More and more governments around the world realise that in order to boost their economic growth, they've got to have a market economy. More state enterprises are going into the market, although many of these enterprises remain controlled by the government. This, he said, puts a completely different focus on the operations of these companies. For the first time managements are accountable to outside investors. "And that changes the whole colour of how they manage and then they become profitable which is good not only for the minority shareholders like ourselves but also for the governments, Mobius added. "We are in some cases in very volatile areas in places like Egypt, Saudi Arabia — we are in the midst of tremendous political changes taking place, but that excites us because we are going to see change which we believe for the most part will be for the better."