Frontier emerging markets are attracting interest. Proponents say they are a natural step in a rapidly developing and globalising economy and not just a reaction to overvaluations in the other emerging markets. Joseph Mariathasan explores the latest additions to the investible world

Emerging markets have become a mainstream component of many institutional asset allocations, yet they may be adopting a narrow approach to gaining exposure. The typical global emerging market equity fund is heavily weighted towards larger capitalised companies and the BRIC countries - Brazil, Russia, India and China - as well as South Korea and Taiwan. The ‘frontier' countries outside the main emerging market indices have been generally ignored.

"Beyond the few large corporations in these markets targeted by international investors lie numerous companies that are overlooked because they do not pass through market capitalisation and liquidity screens," says Kemal Ahmed, the founder and managing member of the emerging and frontier market fund of funds specialist, Old Square Capital.

These companies benefit from a fundamental theme that is being played out over a timescale of decades rather than years, which is driving the incredible performance of emerging markets. It is, of course, globalisation, but for Ahmed there is a different explanation. "It is the fact that globalisation has become a middle class phenomenon rather than the preserve of the elite that marks a profound shift in what has been the human experience from the time the first city states traded with their neighbours and sent their ships into uncharted waters."

The recent performance of emerging markets has generally proved to be a catalyst for a change of perceptions and a raised awareness of frontier markets. "Everyone's hyped on frontier markets at the moment because they don't see a lot of value in the mainstream emerging markets," says John Cleary, founder and CIO of Focus Capital another emerging markets fund of funds manager.

There has been a flurry of new funds exploiting this demand. The Advance Frontier Markets fund launched in June 2007 by Progressive Developing Markets, which raised almost $90m (€61m). According to investment manager Andy Lister, the 50 investors included four UK pension funds as well as many private client and wealth managers. This interest even extends beyond long only equity products with products such as the Permal Silk Road fund, which describes itself as "an emerging market fund of hedge funds, which focuses on many of the markets that made up the ancient Silk Road". All of these are of course now classed as frontier markets and, as Permal Silk Road points out, they have to date seen little foreign investment.

High returns and low correlations?

"The frontier markets today are where emerging markets were 20 years ago," according to Slim Feriani, the managing director of Progressive and this view is repeated by many specialist managers.

Moreover, according to Ahmed, a fundamental characteristic that frontier markets share is their general lack of correlation with other markets. "For example," he points out, "Bangladesh's major trading partners include India and China, yet its impressive market returns have a nearly zero correlation with these two countries or the broader emerging markets."

This is in contrast to emerging markets as a whole where, as Lister points out, "the MSCI emerging markets index has a correlation of 85% with the MSCI World index whereas 20 years ago it would have been 40%." Lister adds that "the S&P/IFC frontier index has a much lower correlation of 40%, while further down the list of frontier markets you get even lower and sometimes negative correlation".

Both Feriani and Ahmed argue that because of the low correlations with other markets, including frontier markets within an emerging markets portfolio, can reduce overall portfolio volatility, while maintaining returns.

Focus Capital's Cleary, however, is more sceptical on this. "The frontier markets have the capacity to do well when emerging markets are outperforming, but when emerging markets are underperforming, they do badly. Frontier markets are not correlated on the upside, but are very correlated on the downside," he says.

Ahmed, by contrast, has the view that frontier markets provide "natural" downside protection, because they have differing market dynamics and capital flows. "Their average return during emerging markets down months is actually positive. This low correlation may well change over time as ‘like' pools of money start flowing into them. Nevertheless, in spite of increased news coverage of these markets, and the launch of several purportedly dedicated frontier markets funds, it is unlikely that the level of portfolio investment flows into these markets will be sufficient to give rise to correlated behaviour.

"Perhaps the most important characteristic of frontier markets is that during periods of market dislocations, frontier markets have tended to retain their independence to each other, giving some downside protection to a portfolio that incorporates a substantial allocation to them."

Ahmed's own strategy, with an absolute return objective, faces no constraints on allocations and Old Square targets as much as a third of its emerging market strategy in frontier markets. Feriani, who is similarly enthusiastic on incorporating frontier markets into his firm's emerging markets product, faces a problem: "As the strategy is a relative product rather than absolute-focused, we cannot get too far away from the benchmark and our weighting in frontier markets of 12% is pretty punchy when you have to be benchmark aware."

Globalisation drives wealth creation

Only time will tell how effective frontier markets are in providing downside protection in a bear market. However, what is more evident is that they, along with the mainstream emerging markets, are seeing the benefits of the increasingly free movement of physical and intellectual capital created by globalisation.

"Today globalisation impacts the day-to-day existence of the middle-income population across the globe and has permanently altered the dynamics of international trade. The WTO is the catalyst, and the impact of the WTO, and GATT preceding it, is only now unfolding," explains Ahmed. The impact on the frontier markets has been little short of revolutionary with "an uncorking of entrepreneurial zeal throughout the universe of emerging markets in every single market except for the mismanaged Burmas," as Ahmed puts it.

"Economic liberalisation has resulted in the removal of previous impediments to growth imposed by governments," continues Ahmed. "This has resulted in dynamic growth across economic sectors and has resulted in a virtuous cycle. This is particularly true for the Asian countries, post debt crisis, that have restructured their economies and are now net creditors to the US."

Countries that are embracing economic liberalism are enjoying the benefits and attracting foreign investors. Jacob Grapengiesser, a fund manager at East Capital, an east European specialist based in Stockholm, says: "In Kazakhstan, when we started, it was a forgotten market, although the country had a stable political system, huge resources and the economy was doing well with a government promoting the education of thousands of students at overseas universities who came back with a good knowledge of finance and capital markets. This is why there is a big difference between Kazakhstan and Ukraine, where this has not happened."

The creation of this rules-based system means that a state cannot afford to de-couple itself from the global trading system because it would then end up becoming a Burma. "If a country wants to ‘plug in and play' it needs to abide by the rules and open up its industries over time to competition. For example, in the case of Saudi Arabia, a relatively new signatory to the WTO, a public equities market that had been largely closed to foreign institutional investors is now gradually opening," explains Ahmed, which is very timely for foreign investors. Lister sees the Middle East as currently one of the most attractive regions in the emerging market universe following the 2006 regional stock markets' crash.

As incomes have risen, there has been a rapid expansion of domestic demand and Old Square Capital finds that many of the managers with whom its funds are invested with are focused primarily on domestic demand driven stories as opposed to emerging markets portfolios in the past that had primarily exporters that earned hard currency. All the emerging countries are experiencing a domestic demand-driven expansion of their economies.

Any outperforming emerging market fund manager is likely to have a fair amount of exposure to domestic demand. "We always try to get exposure to the domestic economy so we have less in commodities than most managers," says Grapengiesser. "Our view is that frontier markets are risky anyway so putting all your money into commodity driven stocks is too high risk. We are trying to capture domestic demand driven growth rather than exports."

Obstacles to investment

Frontier markets are certainly sometimes at the wilder end of the investment spectrum, which can raise issues of corporate governance and the protection of minority shareholders rights. So local managers may sometimes be better placed in this regard than global firms. "In Russia there are many companies controlled by oligarchs, they have learned that they can make more money through floating their companies than through robbing the other shareholders through transfer pricing deals and so on," says Grapengiesser. In Kazakhstan, one of the largest components of East Capital's portfolio, he finds that the local oligarchs are not yet accustomed to dealing with institutional investors.

The critical drawback to frontier markets is their capacity. As Cleary finds: "They have small trading volumes and free floats that are often less than 50%. In some cases, volume is only $50m a day; so one trade can move the market. An example is Zambia. After debt write-offs, the balance sheet looked good and everyone tried to get into local currency debt. But as soon as sentiment changed, they were left high and dry. It was all dominated by a couple of institutions offshore. That is the danger, when countries allow portfolio flows, they can lack the infrastructure to deal with the resulting effects."

Finding managers

Finding managers who can navigate their way through the many problems that need to be overcome in the frontier markets is not an easy task. "There are no real global frontier market experts, only country experts but these tend to be local players and there are significant business risks arising if you use them," argues Cleary. "We prefer to use global players where possible. When we have explored local and regional players, we have found that you can only get so far when you ask questions such as how robust is their process and so on. As we are not keen on frontier markets at the moment, we have not explored further."

Progressive and Old Square Capital, in contrast, regard the ability to pick local managers in the frontier markets as one of their competitive edges. This requires building up networks and relationships, and it can take many years to achieve success.

In the case of Old Square Capital, the initial core portfolio of managers was constructed conceptually by Ahmed and further managers added through the utilisation of a network of contacts developed over 18 years and through on-the-ground research - the fundamental approach being to identify high-calibre firms running strategies that would appeal to a US endowment-type investor. Ahmed was previously managing director at an Ivy League US endowment and by definition this leads Old Square towards boutique firms with niche strategies.

Due diligence on managers will always be a combination of quantitative and qualitative analysis but as Ahmed finds: "Analysing track records is always challenging. The market environment during which certain track records were developed may have included the Asia debt crisis while many emerging managers have built track records over the past five years during which we have only witnessed a bull market." Cleary adds: "It is all very well saying that you have massively outperformed the market, but if you only have a one-year track record, it is not much use to us. We prefer managers who beat the index by smaller amounts over extended periods."

Ahmed is interested in outperformance above the local index where managers have had to benchmark themselves against it, and he also compares the performance with that of the S&P/IFC index. The analysis examines a manager's ability to construct a portfolio that is likely to outperform both a local and the main index over a full market cycle.

"What matters from a risk control viewpoint is how managers have performed in a down market and what the drawdowns have been," says Ahmed. "Old Square Capital's experience has been that value-focused managers generally do better than the index in down markets and have fewer down months, but do not outperform the markets in bull markets although they do capture much of the market's rise. As a result, they have the ability to outperform over a cycle."

The other component of due diligence is qualitative analysis. Multi-managers such as Progressive and Old Square see undertaking visits to managers in each country as essential. "Old Square interviews the manager and the investment team extensively and then spends time visiting a sample of the manager's portfolio holdings to see how well the companies actually fit into the philosophy and process that the manager is espousing," says Ahmed. An allocation to a sub-Saharan Africa strategy run out of Harare for example, included country visits to Botswana, Nigeria, South Africa and Zimbabwe to develop a better feel for the companies owned and micro-trends. He also finds that interviewing a manager can shed light on how well the firm knows its portfolio companies and Old Square prefers managers that conduct deep, bottom up, fundamental analysis.

The opportunity set in emerging markets is greater than just the largest countries and the companies. Frontier markets are attracting interest because their performance over the next few decades will reflect a fundamental and structural change in their behaviour, which as Ahmed explains, "reflect the fact that economic liberalisation has become the undisputed ideology of the market place."

Clearly there are still obstacles relating to corporate governance, capacity constraints in the markets themselves and most critically, the ability to find managers who can overcome these to locate the well-run companies with good growth prospects that offer sustainable returns. But as market cap continues to grow and more countries are becoming investible, frontier markets can only become more important in the future.