The next frontier for investors

Eight of the 10 fastest-growing economies in the world between 2003 and 2013 were frontier markets, according to Singapore-based Mark Mobius, executive chairman of Templeton Emerging Markets Group, a division of U.S.-based Franklin Templeton Investments Corp. Of these, five were in Africa, including Ethiopia, Rwanda and Mozambique.

“Longer term, frontier markets offer the potential for even faster economic growth than emerging markets,” says Mobius. “Overall, I’m excited about emerging markets, but frontier countries are the most exciting part. Tremendous growth is already being reflected in returns.”

U.S.-based Morgan Stanley & Co. Ltd.’s MSCI frontier markets index, which is comprised of 24 countries, gained 18.7% for the seven months to July 31, and showed a one-year return of 27%.

Frontier markets have an even lower correlation to developed markets than emerging markets, which can make them a useful portfolio diversifier, according to Phillip Langham, head of emerging markets equities and senior portfolio manager at RBC Global Asset Management (UK) Ltd. However, he says it’s important to be selective.

“Frontier markets are the ‘emerging’, emerging markets,” says Langham. “There’s an awful lot of frontier countries, but in reality only 15 to 20 are seriously investable.”

Due to the higher risks associated with frontier markets, holdings in these markets should be considered for the aggressive portion of a balanced portfolio.

“Liquidity can vary tremendously, and in some companies and some countries you must be cautious,” Mobius says. “However, it’s improving tremendously.”

As frontier markets are not closely followed by analysts, many investment opportunities are undiscovered.

“Frontier markets aren’t well covered, which means more thorough research is required, and they also tend to be less liquid, and that means taking a long-term approach,” Langham says.

Christine Tan, portfolio manager at Excel Funds Ltd. of Mississauga, sometimes includes exposure to frontier markets in Excel Emerging Markets Fund, and currently holds companies based in Vietnam and Nigeria.

“I am always conscious of liquidity and don’t buy small names,” she says.

Aside from liquidity issues, other potential risks of emerging markets include political instability, inadequate regulation, substandard financial reporting and large currency fluctuations. There is also the potential for trade barriers and exchange controls. Many frontier markets have not matured to the point where their economies are diversified.

Financial stocks tend to be early beneficiaries as frontier economies develop, Mobius says. At July 31, 2014, financial services were the largest component of Templeton Frontier Markets Fund, accounting for 25% of assets under management (AUM), followed by technology at 18%, energy at 10% and basic materials at 9%. The Middle East accounts for about 30% of fund AUM, followed closely by Africa.

“There is a lot of growth occurring in construction, telecom industries and infrastructure, with roads and bridges and ports being built,” Mobius says. “There are incredible real estate opportunities, with rising demand for housing and shopping malls. The biggest barrier is that governments are not efficient and there is still a lot of corruption.”

Templeton Frontier Markets Fund is currently closed to new investors to avoid growing to a size where liquidity issues could create trading difficulties, but Mobius says it will be reopened when appropriate.

Investors can also access frontier markets through exchange-traded funds (ETFs) on international exchanges, such as iShares MSCI Frontier Markets 100, which trades on the New York Stock Exchange and is sponsored by U.S.-based BlackRock Capital Inc., and MENA Frontier Countries Portfolio, which trades on NASDAQ and is sponsored by U.S.-based Invesco PowerShares Capital Management LLC.

This is the final article in a three-part series on emerging markets.