Flavour of the month
30 December 2013
By Hui Ching-hoo
The term ‘frontier market’ has been around since 1992. It was coined to describe a sub-set of emerging markets that were both smaller in terms of market capitalisation, and less liquid.
Despite the upheavals stemming from sporadic economic development and political instability over the years, frontier markets have become significant attractions for foreign institutional investors, the rationale being that their low economic base and minimal investment correlation with their more developed counterparts have helped them to hedge against GFC macro-risk.
A Vanguard report paints a rosy picture of these markets’ future, predicting they are likely to enjoy further economic growth through 2017. That’s reminiscent of rates already seen in the broader emerging markets.
Asia Asset Management asked several fund managers about the growth of frontier markets over the past two decades.
According to Marcus Svedberg, East Capital’s chief economist: “There was hardly any investment in frontier markets 18 years ago, at least not in the way we think about equity investments today. In fact a lot has changed in them over the past 18 months as frontier market popularity has overtaken that of emerging markets. That’s due to two factors. First, the global investment universe is constantly growing as investors search for new instruments and new markets. Second, frontier markets were the main beneficiaries of developed world monetary stimulus because investors were even more intent on finding high yielding bonds, equities and currencies.”
Mr. Svedberg notes that East Capital has been investing in the former east bloc in Europe – that continent’s frontier markets – for more than ten years. Its flagship Eastern European Fund has invested in more than 20 markets in that region, while the benchmark index is limited to five markets. European frontier markets have developed tremendously over the past decade, whether considered by sophistication, depth or coverage: “We continue to rely on in-house research, regular company visits and a combination of bottom-up and top-down research.” Ailsa Cuthbert, associate director, client group at Dragon Capital Group, notes that her firm has been at the forefront of the Vietnamese frontier market scene since its inception in 1994. Since then it has solely focussed on expanding its investment platform after the Vietnamese stock market began operations in 2000.
“Changes in the acceptance level of frontier markets can clearly be seen in moves by companies such as S&P and MSCI providing indices that specifically follow these markets. Globally, they include such geographies as Argentina, Estonia and Nigeria. In Asia, Vietnam is on S&P, MSCI and FTSE’s frontier markets lists. In addition, many investable acronyms such as CIVETS (Columbia, Indonesia, Vietnam, Egypt, Turkey, and South Africa), also bundle these frontier names. Doing this focuses the international investing community’s attention on a handful of possibilities.”
In terms of actual investment in-flows, each frontier market has had its ups and downs, being as much dependent on global economic health as on their own internal situations. Vietnam surged with huge foreign direct investment, was spotlighted as the ‘next Asian tiger’ and then had to endure the hangover that resulted from badly managed over investment in non-productive sectors of the economy. Savvy investors understand these pit-falls as well as the opportunities inherent in frontier markets; and so foreign interest has remained.
“Whereas 18 years ago frontier market investors were generally far more specialised investors, today private banks, wealth managers and even private clients are increasingly focussed there,” Mr. Cuthbert adds.
Taizo Ishida, portfolio manager with Matthews Asia, remarks that indeed now is a good time to invest in frontier markets: “The current economic conditions prevailing in frontier markets are similar to what the ASEAN market experienced a decade ago. For example, the Thai and Philippine market caps were about the same size as many frontier markets today, i.e. somewhere between US$25-50 billion. But now the aggregate Philippine market valuation has grown ten-fold to more than US$250 billion.
“Secondly, frontier markets have vast growth potential still untapped by foreign investors. Bangladesh, for example, has a foreign investment ratio of only about 2%.”
At the same time, the Sri Lankan government has been putting enormous effort into bolstering its economy in the aftermath of the prolonged civil war. Since 2009, the number of foreign tourists has more than doubled to over one million per annum thanks to the government’s stimulus package. These vibrant leisure and tourism industries are expected to generate huge opportunities for foreign investors.
Ms. Cuthbert states that Dragon Capital started out in Vietnam in 1994, fully six years before any type of capital markets existed. As such, the ‘first wave’ of investment was PE-based and from a very specialised group of investors. Since then the ‘second wave’ – rising on the opening of the stock market – has broadened interest in Vietnam for asset managers, pension funds, sovereign wealth funds and family offices: “We started looking at regional frontier markets, and past its traditional investment base in Vietnam, in 2007 when it acquired 23% of the Cambodian micro-finance company Prasac that is now becoming a commercial bank, and similarly in first fund focussed on development using Clean Technology in the Mekong River Region.”
Despite many emerging markets suffering a significant capital exodus recently, as Mr. Ishida sees it, frontier markets stand a very low risk of capital outflow since some of them, such as Vietnam, impose strict monetary control.
“We didn’t see huge redemptions from Vietnam over the past few months with the unfavourable market condition. In contrast, we’ve seen capital inflow into markets such as Bangladesh between June and August as that market is one of the fastest growing in Asia this year.”
Ms. Cuthbert points out that direct access to the market in Vietnam has always been difficult, as even the process of opening brokerage accounts was cumbersome. This has changed over the last few years, however, as the Vietnamese government has taken steps to relax administrative hurdles for overseas investors to open accounts. Most foreign investors look to the country-access funds to provide exposure to the market. Being on the ground is one of the key factors when considering investing in Vietnam. Recent moves to improve liquidity and increase participation in the market have been under discussion, especially around opening the foreign ownership limit on stocks. Still, much remains to be done.
Mr. Svedberg confides that regulatory and infrastructure reform in frontier markets is obviously vital as it improves not only their accessibility but also their transparency. For emerging Europe, the enlargement of the EU and integration with the more developed markets in Western Europe were important drivers of this process.
Speaking about institutional investors’ appetites toward frontier market mandates, Mr. Svedberg says frontier markets have been popular over the past 18 months although the hype may have been exaggerated regarding some places. Tapering will most likely limit the appetite somewhat in the short term. But that does not mean that frontier markets will not play a larger – albeit still very small – role in institutional investors’ portfolios in the future. In other words, short-term flows may dip somewhat in the near future but should recover and grow larger over time.
According to Ms. Cuthbert, institutional investors poured into Vietnam in 2006-2007 when daily volumes reached US$500 million. Since then, a mixture of the Lehman’s saga, global financial crisis, worrying economic indicators and a declining currency has kept them away with daily volumes dropping as low as US$300 million of late.
“However, the Vietnamese government’s successful effort since 2010 to deflate the bubble economy and institute new policies of ‘growth with stability’ has resulted in investors watching and waiting on the sidelines for evidence of this, along with the market bottoming out in terms of valuations. Liquidity remains a problem but the government has approved moves to raise foreign limits from 49% and 59%, which should help matters. This is a clear indication that the government is aware that actions speak louder than words,” she adds.
Mr. Ishida claims that the GDP-per-capita of many Asian frontier markets, such as Laos, Bangladesh, and Cambodia is merely equivalent to the productivity of Japan in the 1950s. So it will take a long time for these countries to graduate from low income to high income economic regimes: But the upside of this is that he doesn’t see any immediate threat of global economic distress taking a toll on these frontier markets’ economies.
Matthews Asia made a foray into Asian frontier markets in April this year with the launch of Matthews Asia Emerging Asia Fund. The fund, which is US domiciled, is expected to invest a substantial portion of its net assets in various emerging markets in Asia including Bangladesh, Cambodia, India, Indonesia, Laos, Malaysia, Mongolia, Myanmar, Pakistan, Papua New Guinea, Philippines, Sri Lanka, Thailand and Vietnam.
“Wages in these Asian countries have significantly changed consumption behaviours. We are also looking for companies which can improve the living standards of local people,” Mr. Ishida adds. “Region wise, India accounts for the largest portion of the portfolio at around 15%, with Sri Lanka, Bangladesh, and Vietnam each making up a further 10% plus.”
Mr. Ishida says that a lack of liquidity is the major concern when foreign investors consider investing in frontier markets. Most companies making them up are micro cap with valuations of less than US$50 million. Such market caps are too small to lure sizeable global investors. This, combined with the limited availability of investment choices and immaturity of potential investors’ mindsets means fund managers can ill afford to launch ‘purely’ Asian frontier market funds.
Asked whether frontier markets really have the potential to become emerging markets, Ms. Cuthbert notes: “In terms of Vietnam becoming part of the next BRIC phenomena we feel that this may be some way off. Brazil, India, Russia, China, and South Africa have populations many times that Vietnam. And while Vietnam’s population is youthful, educated and dynamic, it is also felt that an emerging economy is one where ‘the politics matter at least as much as the economy to the markets.’ This is unlikely for the foreseeable future in Vietnam. However, other perquisites such as increasing economic freedom, an expanding middle class, improving standards of living, social stability and tolerance, as well as an increase in cooperation with multilateral institutions have been evidenced.”
Mr. Svedberg points, as a prerequisite for success, to markets that prove sustainable from an economic, financial and political point of view combined with a certain size: “The last point refers not only to the size of the particular country/economy but even more to the size of its financial market, which can be expanded through privatization and financial market reform. We are, for instance, optimistic about the markets in Europe that already have or will join the European Union. As such, our frontier market mandate has certain exposures to primarily equities, private equity and real-estate vehicles in frontier Europe.”
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