A Realm of Opportunity: The Untapped Potential of Frontier Market Investing
By Avery Whelan
In a volatile foreign investment landscape, frontier markets arise as a unique opportunity to diversify away from global systematic risk and generate high growth returns.
What are Frontier Markets?
As the Russia-Ukraine war rages on, the Israel-Palestine conflict persists, and Chinese geopolitical tensions loom, foreign markets appear to exist in a fixed state of uncertainty. However, it is crucial to identify the differences in behaviour between classes of foreign markets. In the FDI inflow hierarchy, developed markets such as the U.S. and U.K. sit at the top. These nations are defined by industrialized economies, established regulatory infrastructure, and high income per capita. Conversely, emerging markets subsist in a transition stage as they progress from developing to developed nations and are characterized by low income per capita, market fluctuations, and accelerated economic growth. China, Russia, and India are prime examples of emerging markets.
Frontier markets are a step below this; they are considered superior to the least developed markets but fail to meet the criteria of emerging markets. The Financial Times Stock Exchange (FTSE) categorizes frontier markets based on their Quality of Markets Assessment Matrix. The FTSE requires frontier markets to possess a formal stock-market regulatory authority, no drastic restrictions on capital repatriation, a rare occurrence of failed trades, T+5 or better in regards to clearing and settlement, and a timely trade-reporting process. Bloomberg lists roughly 30 frontier markets mainly in Asia, Africa, the Middle East, and Eastern Europe. Consider countries like Jordan and Romania whose markets resemble the frameworks of emerging ones, only on a smaller scale. Partial ease of capital flow, limited foreign ownership, and modest company market capitalization are identifying traits that signal both uncertainty and opportunity.
Upside: Natural Risk Diversification, Strong Economic Drivers, and Rapid Growth Potential
Frontier markets are natural risk diversifiers, as securities do not move in tandem with those of developed and emerging markets. A significant challenge for investors in recent years is the rising correlation of asset classes. Due to the increasing interconnectedness of global markets and their supply chains, investments are now less diversified than ever before. As emerging markets integrate further into world trade and converge towards their developed counterparts, they establish similar risk and return outcomes. A sharp swing in major markets, demonstrated by events such as the Russia-Ukraine war, poses drastic macroeconomic consequences and upsets overarching portfolio performances. In contrast, frontier markets are relatively insulated from one another and disconnected from global trends, which indicates portfolio diversification benefits. A study by FTSE Russel found a cross-country correlation of 0.30 between frontier markets, compared to 0.52 for emerging and 0.70 for developed. Over a 12-year period, the Morgan Stanley Capital International (MSCI) Frontier Markets Index had an average correlation of 0.48 to their World Markets Index, while the Emerging and World Markets Index shared an average correlation of 0.87. Evidently, frontier markets exhibit consistently low levels of beta exposure attributed to their protection from global volatility.
The International Monetary Fund (IMF) predicts that nominal and real GDP growth is set to be higher in frontier markets compared to rival countries for several years into the future, underpinning favourable economic development. The World Economic Outlook forecasts that economic growth in developed economies will fall to an average of 2.3% until 2026, while growth in frontier markets will be boosted to 4.8%. Dramatic rises in population growth and urbanization, paired with rich natural resources and a cost advantage, are key drivers. Population growth in frontier markets ranges from 1.5% to 2%, in contrast to developed markets which currently stagnate below 0.5%. The United Nations estimates that nearly half of the global population will compose of those living in frontier markets by the end of the century. Additionally, trends towards urbanization suggest potential for reduced unemployment, increased labour productivity, and higher levels of trade engagement. Many frontier markets, similar to their emerging counterparties, boast an abundant supply of natural resources, particularly concentrated in Africa. Raw material availability may stimulate expansion of commodity sectors and uphold economic growth for the long-term future. In terms of manufacturing, frontier markets maintain a new cost advantage over competitors. In analyzing China, an emerging market, and Vietnam, a frontier market. China is one of the most popular outsourcing destinations in the world; but as the economy advances, so do labour costs. Consequently companies are beginning to turn to Vietnam, a more cost effective neighbour, as a manufacturing source. It must be acknowledged that leveraging a country’s natural resource supply and cost advantage often leads to environmental and worker exploitation alongside the desired economic growth.
The upside of frontier markets from a growth investment perspective is clear. They remain undervalued from a market capitalization perspective. Frontier markets formulate 36% of the world’s population and 15% of its GDP, yet only make up 0.3% of global market capitalization. This striking imbalance illustrates a likely disparity between the intrinsic value of frontier market firms and their actual price. Specific high-growth opportunities must be identified by firms before others to realize possible capital appreciation gains. As the co-manager of the BlackRock Frontiers Investment Trust (BRFI), Sam Vecht, expresses: “Understanding the economic and business cycles of the underlying countries is a crucial part of the stock selection process.” Each frontier market bears unique drivers that carry rapid growth potential. In Africa, fintech presents itself as a swiftly expanding industry. Currently, 57% of the continent’s population does not own a bank account. With a young and fast growing population that lacks access to financial services, this sector showcases excellent growth potential. Circling back to Vietnam, its average economic growth is projected to be 7% by 2025, owing to its competitive cost advantage factor. Companies such as Nike, Intel, and Samsung continue to allocate production capacity to Vietnam as they shift away from dependency on China. Continuous investment and growth in frontier markets allows them to flourish and develop further. Another example is Pakistan, who’s main stock index surged over 25% from 2009 to 2017. As a result, the country was promoted to emerging market status shortly after. An economy's relative growth inevitably levels off, but competitive advantages such as resource deposits can persist and impart new opportunities for value investing.
Downside: Idiosyncratic Risk Factors and Illiquidity
While frontier markets are more resistant to global systematic risk, they are also sensitive to individualized risk elements. Shaky governance structures and complex geopolitical relations derive economic and political risk. As outlined in a previous LBER article, Argentina faces rampant inflation, a gaping federal deficit, and the collapse of the peso’s value. As the nation’s radical new president Javier Millei attempts to implement dollarization, commodity prices soar and the devaluation of Argentine currency skyrockets. The country’s economic future is unpredictable to state the least, far more than most emerging and all developed markets. Lebanon, another frontier market, resides in a geopolitical hotspot and is at the front and centre of constant political strife, from religious clashes between Islamic and Christian presences to prominent political party Hezbollah’s involvement in proxy disputes, most recently including their backing of Hamas in the Israel-Hamas war. Lebanon’s political state reflects that of numerous frontier markets. An underdeveloped economic and political structure delivers growth investment opportunities, but that is never accompanied without instability and risk.
A paramount concern surrounding frontier markets is their liquidity risk. Sovereign debt markets, in particular repo markets, are typically very underdeveloped. Without them, economies fail to anchor an overnight interest rate and yield curve. As a consequence, floating rate products and their derivatives are difficult to use, which scares investors away. Furthermore, these foreign assets are typically not backed by well secured funding arms, which exacerbates the illiquidity issue. Although, it may be argued that the liquidity issues are offset by the global systematic risk premium, or that it is already priced into the market value of the securities.
Investment Strategies
Local and state parties are the chief investors in frontier markets, while foreign presence is weak. Funds are typically actively managed, as passively managed investments such as exchange-traded funds (ETFs) comprise only 10% foreign investment funds. Notable players in the hedge fund and asset management sphere include the BlackRock Frontiers Investment Trust, the Morgan Stanley Frontiers Emerging Markets Equity Fund (FFD), and the T. Rowe Price Africa & Middle East Fund (TRAMX). A mix of growth and value investment strategies is customary when approaching frontier markets; a healthy risk appetite is necessary. The aforementioned funds are joined by private equity firms who strive for returns through Foreign Direct Investment (FDI). These various funds and approaches pursue growth returns and navigate unique challenges as they venture across a new frontier.
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