April 2011
Financial services
The new frontier: understanding the opportunities, knowing the risks by Dan Shoenholz 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. 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.1 According to data provider EPFR Global, investors put US$2.6 billion 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. The drivers of frontier economic growth fall into three broad categories. 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. 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. 1
Frontier countries are usually defined as those with economies whose size and growth are below Brazil, Russia, India and China (BRIC) and the next tier down, Colombia, Indonesia, Vietnam, Egypt, Turkey and South Africa (CIVETS), although in practice some market participants deem CIVETS such as Vietnam to be “frontier.”
Assessing the risks Frontier markets appear to offer a potential source of alpha for active managers, as well as opportunities for portfolio diversification. However, these potential benefits do not come without risks and challenges. These risks should be considered when determining which particular markets to pursue and recognized in investment processes and risk-and-return targets. Regulatory and trading-execution risk: although increased interest in frontier markets has been enabled by market liberalization and increased openness to non-local investors, market barriers should not be underestimated. Foreign ownership restrictions, currency limits, local custody rules, local funding and registration requirements are widespread and sometimes difficult to navigate. Some markets even require foreign market participants to execute trades via local brokers. 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.
under 20% of GDP; the figures for emerging and developed markets were above 40% and 50%, respectively.
Transaction costs: in many markets, high local transaction fees and commissions inflate trading costs. Currency risk: investors that seek to build a frontier market portfolio need to be aware that they face a higher risk of investment exposure to potentially volatile currencies.
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
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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The new frontier: understanding the opportunities, knowing the risks
Governance risk: standards of corporate governance and financial reporting among listed companies in some frontier markets can be uneven. Sector and sovereign risk: part of the attraction of frontier markets is their low correlation with developed and emerging markets. However, investors should be aware that frontier markets are dominated by a few sectors, thus a sizeable allocation can result in concentrated exposures to certain sectors. Frontier market equities are highly exposed to sovereign risk. Liquidity risk: illiquidity is a feature of
many frontier markets. Investors may be unable to execute trades when they want, or at the size they want. Bid-offer spreads can also be relatively wide. Operational risk: in some frontier equity markets, investing entails increased operational risk. Failed trades may occur more frequently than in developed markets, as settlement processes may be less standardized, less automated and more prone to errors. Political risk: as the recent political unrest in the Middle East illustrates, many frontier markets have fragile systems of government that can be prone to instability. Turmoil can in turn lead to rapid declines in the market value of securities traded in impacted countries.
be factored into the decision-making process around return targets, and whether a manager can create an investment product with an attractive risk-reward profile. A local presence can have significant potential benefits in this regard. Being on the ground can also help an organization monitor and mitigate other key risks such as a lack of disclosure in financial reporting or the potential for political uncertainty to destabilize markets, and to source alpha.
Final thoughts Frontier markets undoubtedly offer potentially compelling investment opportunities that satisfy investor demand. Now is a good time to consider
developing new products to tap these opportunities: frontier markets are growing rapidly, but are still nascent enough to offer significant return potential and attractive correlation characteristics as globalization unfolds. But asset managers must work diligently to assess whether a frontier product is a good fit for them; performance potential and asset gathering are only part of the equation. To be successful in developing an effective frontier investment capability, managers must ensure that their approach to risk management takes into account the particular blend of risks that these markets entail, both inherently and in relation to their other exposures.
Mitigating the risks Whether an asset manager is considering launching a passive product, seeking alpha generation or playing the thematic growth story, risk must be managed carefully. A single-country or regional approach to frontier-markets investment can create very significant sovereign and sector/ stock concentration risks; limiting the investment universe in this way results in few potential securities that meet minimum capitalization standards or other criteria. This strategy can also limit the amount of capital that a fund can put to work because of the risk that an investment in a given security will be too large to trade effectively. In our view, a key attraction of frontiermarket returns is their lack of correlation to each other, and to developed and other emerging markets. This means that a selling point for frontier markets is that adding them to a broader investment strategy can actually reduce overall risk and improve risk-adjusted returns. Certainly, issues related to illiquidity, trade execution and settlement should
The new frontier: understanding the opportunities, knowing the risks
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Dan Shoenholz is a senior manager in the transaction advisory practice of Ernst & Young LLP. Dan is based in New York and can be reached at +1 212 773 4517 or dan.shoenholz@ey.com.
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Š 2011 EYGM Limited. All Rights Reserved. EYG No. J00375 1103-1241250 NY This publication contains information in summary form and is therefore intended for general guidance only. It is not intended to be a substitute for detailed research or the exercise of professional judgment. Neither EYGM limited nor any other member of the global Ernst & Young organization can accept any responsibility for loss occasioned to any person acting or refraining from action as a result of any material in this publication. On any specific matter, reference should be made to the appropriate advisor.