Emerging Market Equities: Wild frontiers
David Turner finds that illiquidity, political and ESG risks all conspire to put a limit on pension fund allocations to the high-growth potential of frontier markets
Frontier markets present a teasing conundrum for pension funds. The returns in these markets, which have not quite made the transition to fully-fledged emerging status but are considered to be on their way, can be stratospheric. The Ghanaian stock market, in the heart of sub-Saharan Africa – considered by many to hold the most promise of any frontier region – was up 88% on the year by November 2013. National indices in other frontier regions, including the Middle East and the less developed parts of south-east Asia, have also periodically risen at breakneck speeds.
Even advocates of frontier investment, however, acknowledge their illiquidity – which hampers efforts both to get into markets without bidding up the price, and to get out of them without having to resort to a fire sale.
“There is limited scope for a pension fund to invest in this asset class,” says Kevin Daly, manager of a frontier bond fund, investing primarily in government debt, launched by Aberdeen Asset Management in September. A pension fund might relatively easily be able to find a home for $100m (€73.9m), but investing $200m and more could be harder, he says.
Daly’s comments are echoed by his colleague Mike Turner, head of global strategy and asset allocation. “You have to lock away your money for a certain amount of time or you’re going to be penalised,” he noted at a session on pensions at a recent Aberdeen Asset Management investment conference. For this reason, he proposes a limit to pension fund investment in frontier markets of 3-4%, and possibly 5% for the “very adventurous”.
But some argue that the illiquidity can be exaggerated. Asked how long it might take to trade out of a position in a frontier market stock, Claire Peck, client portfolio manager for emerging market equities at JPMorgan Asset Management, says calculations based on on-exchange trading volumes on Bloomberg suggest it might take more than 100 days for some stocks.
However, a good frontier market manager will be able to close most positions earlier than that via off-exchange buyers. She also makes the point that the illiquidity could present an advantage for pension funds who do not face frequent liquidity requirements and can take a longer view.
Even those pension fund managers not so worried about illiquidity have other worries about frontier markets, however.
Mark Fawcett, CIO of Nest, the workplace defined contribution pension scheme set up by the UK government in 2011, cites the reasons why Nest has no money allocated to frontier markets. These include fears over corporate governance and the environment.
“Is there a tradition of respecting property rights in that country? You don’t want your assets to be appropriated by the government,” he says. “And if you believe that climate change is happening, Africa is one of the high-risk areas to be in.”
Peter Lindegaard, CIO for Danica, the Danish pension provider, also cites concerns over property rights, as well as reputational damage to pension funds. He notes that in Denmark, where many pension funds have bought emerging market government debt, the media has raised concerns about investment in ‘blood bonds’ – securities issued by governments that were, in the media’s view, persecuting their populations.
Peck acknowledges that frontier markets present more ESG issues than other markets. This is, she says, partly because much of the investment is in natural resources. It is also partly because frontier market companies often have links with governments, which may place more weight on protecting their own interests than those of minority shareholders. She thinks, however, that these tricky waters can be navigated.
“A good guide to whether minority shareholders are likely to be treated well is to look at whether the company pays high dividends,” she suggests, pointing out that dividends tend, on average, to be lower in frontier than in emerging markets – though not uniformly so.
One might be forgiven for asking why any international investor puts money in frontier markets at all. For other high-risk assets the reward lies in the ability to buy at cheap prices – but frontier equities do not currently look cheap, though some investment-grade frontier bonds, such as Nigerian local government paper, offer double-digit yields. At the end of October 2013 the MSCI Kenya index’s trailing P/E ratio was 15.2-times, with Vietnam at 14.3 and Kuwait at 18.1 – all above the MSCI Emerging Markets ratio of 12.4-times.
Frontier investments present two great attractions, however: inefficient markets (the flip side of that illiquidity and the benefit that long-term investors can exploit), and promising economic backdrops.
“Many of these countries have very few asset managers looking at their securities: that means more inefficiencies and pricing anomalies,” says Peck.
The economic backdrop is the prospect of extremely high growth in some of the underlying economies.
“Sub-Saharan Africa is the most interesting region within frontier markets,” says Phil Edwards, principal and pension fund specialist at Mercer. “It has an exaggerated version of the demographic story that’s behind emerging markets’ growth. A lot of the countries will see labour market growth that will far, far surpass that of many emerging and developed economies. This should power their economies for decades to come.”
Advocates of sub-Saharan investment say that this growth could, in particular, boost stocks that are more likely to benefit from the increase in domestic household consumption, such as mobile-phone company stocks.
But Edwards acknowledges that “this is a very long-term story” with a lot of political risk. For pension funds he suggests an investment of perhaps 2% of the overall portfolio, within the overall emerging markets allocation – enough for pension fund managers to dream of a decent boost to their funds if all goes well, but not enough to plunge their funds into crisis if the dream goes sour.