Looking beyond emerging markets to "frontier" economies
Updated : 12/17/2012 15:15 GMT + 7
CHICAGO – With China, Brazil and India hitting icy patches on their economic growth paths, investing in even younger emerging markets looks promising.
The so-called "frontier" economies offer diversification and profit opportunities as big global investors look for low-cost labor and resources. Most of these 25 or so countries won't appear on most individual investors' radar screens, though. They range from Bangladesh to Vietnam and are expanding due to industrialization or global demand.
Vietnam, for example, benefiting from normalized relations with the U.S. and membership in the World Trade Organization, is one of the only Asian countries to have grown faster than China since 2000, according to the McKinsey Global Institute. The country's manufacturing sector alone grew at a 9-percent annual compounded growth rate from 2005 to 2010.
Part of the appeal of frontier markets is their growing younger populations, which produce a "demographic dividend" that allows for competitive labor rates. Many of these countries are also blessed with natural resources from land to oil, which is the case in sub-Saharan African countries like Ghana, Nigeria and Kenya. Even established Gulf states such as Kuwait and Qatar offer growth.
Commodity demand from the largest developing countries such as China and India will focus even more attention on the frontier countries. China has become the largest single trading partner of African countries as well as South American nations such as Brazil and Chile. Ultimately, China's growing middle class and industry will tap every country for resources like copper, iron ore, coal and other metals.
While the future opportunities are numerous, the vehicles available to invest in frontier markets are few. There are several single-country, exchange-traded funds available and two index funds, but they pose a number of problems.
Two frontier index funds - Guggenheim Frontier Markets ETF and the iShares MSCI Frontier Index Fund - rely upon capitalization-weighted indexes that concentrate holdings in a handful of small countries. Some of the indexes used to track frontier markets are too heavily skewed to a handful of countries to be able to claim the mantle of diversification.
The FTSE Frontier 50 Index, for example, has 46 percent of its weighing in Nigeria and Qatar. The next-largest stake is Kenya, at 9 percent as of October 31. As a result, the indexes don't provide a broad-enough basket of country representation.
The iShares fund, for example, has nearly half of its holdings in Kuwait and Qatar. Although those oil-rich countries will benefit from higher petroleum demand and prices, they concentrate risk in two countries and one region. The Guggenheim fund, in contrast, puts more than half of its assets in Chile and Colombia, although it owns smaller stakes in Egypt, Peru, Argentina and Kazakhstan. Almost one half of the fund is invested in financial and energy stocks.
Actively managed funds may offer some better opportunities. Since the companies being eyed are thinly traded and researched relative to global mega-caps, specialty managers might provide an advantage.
The Templeton Frontier Markets A fund, led by manager Mark Mobius, invests across 11 sectors in 10 regions with three quarters of its holdings in emerging Africa, Europe and the Middle East. The fund is up more than 22 percent year-to-date through December 12, compared to an 11-percent return for the Guggenheim fund. The iShares fund, which has only been in existence since September 12, is up about 3 percent for the past three months.
The main drawbacks of the Templeton fund are its costs. There is a 5.75-percent sales charge for the fund's "A" shares as well as high management expenses – 2.15 percent annually – and 0.3-percent so-called 12b-1 marketing and distribution fee. ("A" class shares typically carry front-end commissions.)
As with many vehicles in emerging markets, frontier fund returns show a dramatic amount of volatility. The Templeton fund's best year was in 2009 – a rebound year from the debacle of 2008 – when it returned almost 44 percent. The fund gained almost 19 percent in 2010 before losing nearly the same amount last year.
Political risk will also roil the frontier markets. It may be some time before political stability comes to nations like Nigeria, Egypt, Pakistan and South Africa. As frontier economies have a symbiotic relationship with developing and mature countries, they also get a flu when their largest customers sneeze. Nearly all of developing Africa, Southeast Asia and South America will feel the adverse impact of a sluggish China or United States. The stock markets in the frontier nations are also not as robustly regulated nor as heavily traded as they are in developed countries, so that's another caution.
Frontier markets should be part of a larger strategy to globalize your portfolio away from northern, slower-growing, older countries – think Europe and Japan – into younger countries that are mostly in the Southern Hemisphere. This "youth movement" may not show immediate gains, but should show long-term rewards as resources become even-more valuable commodities as the world's population soars.