The road less travelled not always paved with gold

Gregg Wolper | 14 Mar 2019

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Ho Chi Minh, the capital city of frontier market Vietnam

Bold investors look for an advantage by exploring relatively untapped realms. They hope that taking these paths before they are discovered by the masses will result in greater returns, more than compensating for the uncertainty involved.

A side benefit, for some, is a perceived lack of correlation with other assets – meaning that, because they’re off the radar screen, they won’t drop in tandem with other asset classes when global investors get skittish.

Frontier markets are attracting attention from such investors.

In this context, "frontier" refers to countries classified by ratings services as having an investment infrastructure that's a step below those of emerging markets such as Brazil and India.

Examples of frontier markets include:

  • Vietnam
  • Ukraine
  • Kuwait.

It sounds exciting, but investors have good reason to be wary.

Concentration and liquidity risks

One issue is that these countries don’t house too many attractive companies that are publicly traded rather than state- or family-owned.

Even if an investor guesses correctly that economic growth in frontier markets will take off, it doesn’t necessarily mean companies listed in those markets will reflect that growth.

In addition, the shares of the available stocks sometimes don’t trade very often, or in large quantities – which can make it difficult to build a meaningful position.

More dangerously, selling a stock if troubles arise – or simply when the stock has risen to reach a manager’s price target – can be much more difficult than it would be in a bigger, more-established market. Sometimes, it’s nearly impossible.

Frontier-markets funds tend to be concentrated as well. They routinely have between 40 per cent and 50 per cent of assets in the financial sector.

That’s partly because the most liquid and established stocks tend to be banks. In addition, some managers think that if a country’s economy does surge and benefits more of the populace, the banks will be most likely to reflect that improvement through issuing more loans, mortgages and other products.

Some frontier market funds have substantial stakes in individual stocks. For example, National Bank of Kuwait comprises 9 per cent and 6.2 per cent of the total assets in the US-domiciled Ashmore Emerging Markets Frontier and Templeton Frontier Markets funds.

Frontier market funds are expensive, too. Most have annual expense ratios of at least 1.5 per cent of assets.

Weighing up risk and reward

Investors, unwisely but perhaps understandably, might be willing to put aside all of these negatives
if their performance left conventional emerging markets funds in the dust.

That might happen in the future, but their history offers a cautionary tale.

Templeton Frontier Markets has trailed the diversified emerging-markets Morningstar category average for five consecutive years, including both rallies and downturns, often by alarming amounts.

In 2014, the fund’s A shares lost 15.1 per cent, while the category dropped just 3 per cent.

In 2017, the fund gained 22.8 per cent, but the category average soared 34.2 per cent

The performance of other frontier-markets funds wasn’t as bad, but they commonly lagged the average for the category, which is made up primarily of conventional emerging-markets funds.

One reason frontier-markets funds have generally moved in the same direction as emerging-markets funds, though to very different degrees, is that the former tend to invest in some of the smaller emerging markets, such as the Philippines, in order to expand their universe.

Although past performance should be kept in perspective, it’s crucial to recognise one particular aspect of this history.

While the proponents of frontier markets investing are correct to assert that these funds don’t move in lock step with the performance of emerging-markets funds, that can often work to the disadvantage of frontier-markets investors rather than to their benefit.

In the meantime, shareholders are paying a hefty fee for the privilege.

This article was previously published in the FundInvestor newsletter published by Morningstar in Chicago, US.

 

This report appeared on www.morningstar.com.au 2019 Morningstar Australasia Pty Limited

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