Attention is turning to frontier markets given that several high-profile emerging market equity managers have recently closed to new business and developed stockmarkets remain close to efficient.
These countries, spread across the globe, typically sit below emerging markets in terms of scale, market capitalisation and liquidity. The largest countries of the MSCI Frontier Markets index include the likes of Colombia at 20 per cent and the Philippines at 16 per cent.
Selecting fund managers that run money in these parts of the world is more challenging than usual, but it is certainly worth the effort given the less efficient nature of these markets and their growth dynamics. Populations are often far younger on average than developed markets, with the penetration of financial services and consumer goods still at very low levels. This should result in strong economic growth and rich rewards for appropriately positioned companies.
But these countries come with a host of challenges for investors. With the regions so disparate – in terms of geography, culture and languages – a vast range of skills is required. It is not common for company management, certainly below board level, to speak English. No individual market has many stocks and total market capitalisations are small.
For example, the MSCI Frontier Markets index comprises 25 countries, fewer than 200 companies, has only one stock with a market cap above £10bn and no one country provides more than 18 index constituents.
Heightened concerns exist about corporate governance as well as environmental and social issues. Board composition is not always up to developed markets standards, while pollution and labour relations can often be ignored. Liquidity can be thin and episodic, so it is essential that position sizing and total assets under management are carefully controlled.
Visits to sites and plants are essential to ensure that the purported assets do indeed exist. Similarly, investors want evidence of an environment that nurtures capitalism – with regards to political risk, no one wants to find that the government has expropriated a firm’s assets.
From a business perspective, it is not yet a hugely profitable undertaking to manage frontier market equities and so it is not affordable to have ranks of analysts.
This is because the size of the universe is small, resulting in a limited size of manageable assets. Assuming that a performance-related fee structure is not feasible, the result is often either a very small team or having the analysts that cover emerging markets ‘tagging’ coverage of frontier markets to their remits. Clearly neither structure is optimal.
All these issues mean that a significant edge can be attained in the asset class and the rewards can be large, yet the structure is vitally important. This leads us to seek out frontier market managers that specialise by region, such as African equities or frontier Asian equities, as the manager can focus on one area and operate with a lower cost base.
This should ultimately result in the highest likelihood of future outperformance in what is a relatively inefficient asset class.
Ian Aylward is co-head of multi-manager at Aviva Investors
