Why Invest in Frontier Markets?

Frontier markets are less volatile than emerging markets - they are also uncorrelated to their peers and offer significant dividend yields, says BlackRock's Sam Vecht

Emma Wall 18 August, 2014 | 12:23AM
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Emma Wall: Hello and welcome to the Morningstar Series, Why should I invest with you? I'm Emma Wall and here with me today is Sam Vecht, manager of the BlackRock Frontiers Trust (BRFI).

Hello, Sam.

Sam Vecht: Hello.

Wall: So what exactly is a frontier market?

Vecht: That's a really good question. There are lots of different definitions as to what a frontier market is. We typically use the MSCI definition, and just to give you some background to that, there are about 190 members of the United Nations, 20 or so are classed by MSCI as developed; the U.K., the U.S., we don't invest in those. About another 20 or so are classed by MSCI as emerging; Brazil, Russia, et cetera, and again, we don't invest in those. There's about 20 or so that are classed by MSCI as frontiers. We do invest in those and there is about another 130 or so countries in the world that we can invest and that are, say, even below frontiers and we definitely consider those, but don't obviously invest in all of them.

Wall: I mean ever since the credit crisis, there seems to have been this concern with investors about capital preservation, and then as things have improved very much, about income, where do frontier markets fit in to this portfolio, because they are a more risky strategy than emerging, aren't they?

Vecht: Well, that's an interesting point again. For the simple reason that, if one looks in a simple measure, like volatility, they're actually less volatile than emerging markets, which certainly many people don't realize, so even the individual countries are quite volatile and one thinks of countries like an Argentina or a Bangladesh or a Nigeria, they are very volatile. But put them all together, they don't have very high correlation. So when Nigeria is going up, Argentina is going down and Sri Lanka maybe flat, unlike emerging markets, where if the U.S. market is down, probably all of the emerging markets will be down, the frontier markets aren't highly correlated.

So on the one hand, they are not very volatile. Of course, individually, they are risking the significant risks of investing in frontier markets. It's also worth highlighting that many frontier markets have very significant dividend yields, various historical and cultural reasons, and so frontier markets actually yield considerably more on average than either emerging or indeed developed markets.

Wall: Frontier markets, as you say, are those that are smaller markets and we find that with developed markets, the stock market and the economy are not so correlated. But as you move down that scale, that correlation becomes more entwined, certainly in some emerging markets. Is that the case in frontier and is it a concern for you because of that?

Vecht: I would actually question that supposition. Academic research has shown there is no correlation between GDP growth and market performance. I think it's fair to say when GDP declines, markets go down. But when GDP rises, market don't necessarily do well, and therefore, it's a range of macroeconomic factors as well as politics one have to consider in frontier markets; inflation, current account deficits, those are very, very significant as well as doing a lot of bottom-up research.

Wall: To that end then because as you say, politics can be one of the factors that determine stock markets, how concerned are you by a lot of the bad news currently in the regions that have frontier markets in them?

Vecht: There is always bad news in many parts of the world. It's an unfortunate fact that there are horrific scenes we see on our television screens every single night. The key question for us is what's actually priced by the market. So if bad news is already heavily in the price then occasionally we will have investments. So we do have exposure to Iraq, for example, at the moment. We do have exposure to Pakistan, two countries attracting pretty negative press at the moment. The key question at any point is how much of that bad news, how much of that political uncertainty is in the price and other countries, where people seem to be discounting or ignoring political problems will probably stay away from those countries.

Wall: So then where are the opportunities? You've mentioned that the price is a big positive for you. Where are you seeing those opportunities?

Vecht: In frontier markets, we are seeing opportunities anywhere from Saudi Arabia, possibly entering a collection of indices.  Historically foreigners have had challenges investing there, that's changing in the first quarter of 2015. So, an interesting technical aspect for Saudi Arabia. We're interested in Romania, a country growing significantly for the first time in eight or nine years. We're interested in Sri Lanka and Bangladesh and Pakistan, all the countries sort of, of the Indian subcontinent, all for their own reasons growing up quite nicely and within Africa, probably the only country which we're somewhat in favour of is Nigeria.

Wall: Sam, thank you very much.

Vecht: Thank you.

Wall: This is Emma Wall for Morningstar. Thank you for watching.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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Emma Wall  is former Senior International Editor for Morningstar

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