In the current economic climate frontier markets could be viewed as something of a risky venture. However, they do bring other opportunities, such as portfolio diversification. Giovanni Legorano reports
Pension funds struggling with underfunded positions and targeting more profitable investments have increasingly looked at non-traditional assets during the last few years.
More recently, the financial crisis has intensified the quest for assets uncorrelated with mainstream equity markets and the idea of de-coupling was often regarded as an important factor driving an investment choice on assets or markets.
However, recent events have shaken most of the hypothesis on which analysts based their recommendations. Meanwhile asset managers questioned a number of the typical assumptions made when looking to invest in frontier markets.
Nomura Asset Management UK, product specialist for the global emerging markets strategy, Fraser Hedgley, pointed out the world is becoming increasingly globalised.
While correlation of frontier markets tends to be quite low in stable market conditions, Hedgley said in times of global crisis correlation tended to rise.
He added: “All markets have been hit and frontier markets have been no exception. In particular, frontier markets can be hit very hard because of their extremely volatile nature and low liquidity.”
The severity of the crisis has led investors to flee from assets considered risky and to look for shelter into what was perceived as defensive positions. Frontier markets are considered risky investments, even though asset managers often point out there are differences among countries within that definition and that a decoupling of asset performance had held, particularly when considering certain Asian frontier markets.
Varma, director of equities, Ari-Pekka Hilden, said: “I think the turning point for the correlation to increase was the Lehman case. Until then, there was still decoupling in Asia which was holding quite well. After that the correlation started to increase very rapidly.
“In times of crisis, very little risk is taken. Pension funds are underweighting in risky assets and conditions have to change for institutional investors to take on more risk again.”
Other experts disagreed with the idea of de-coupling challenging its theoretical basis.
“I find the whole concept of decoupling deeply objectionable,” said Ashmore Investment Management’s head of research, Jerome Booth. “The whole process of globalisation is one of greater interconnectedness, meaning every country can be affected in one way or another. Therefore, the idea of decoupling becomes much less relevant and the burden is more broadly spread.”
In addition, Booth continued: “Whether Africa and other frontier markets appear not to be coupled is because they did not have globalisation in the first place. Emerging markets in general are very strong in terms of systemic risk, but frontier markets have less connection. Other than being decoupled, these markets are much less liquid and fundamentally not yet keyed in.”
He added the whole approach was rather based on a different idea – the core-periphery model, the vision that there are core countries and periphery countries. He said: “This could be still largely the case for frontier markets, but for emerging markets it is not a useful way to think about the world anymore.”
Investors such as hedge funds which had been tapping into frontier markets, particularly Africa, have had remarkable returns for the last two years gaining interest from investors around the world, mainly with a long only perspective.
WestLB Mellon Asset Management’s emerging markets equity fund manager, Glen Prentice, said investors soon realised while there was a positive correlation between frontier markets – mainly the Gulf area and Africa – and the mainstream markets, this was relatively low, broadly in the range of 0.3% to 0.4% with other asset classes.
As a result, Prentice said those assets really came on the radar of pension funds in 2007, providing a good diversification benefit with a low correlation.
He explained: “In terms of decoupling, there certainly was a safety aspect that was perceived to be available in the frontier markets of the Middle East, certainly through to the first half of 2008 when commodities prices, particularly oil, generated very high revenues for these economies. The Gulf market last year was one of the better performing asset classes and the first half of this year it was also outperforming on a relative basis.”
This could be perceived as decoupling, Prentice said, even though he pointed out oil revenues were the only factor causing a divergence in performance. The situation drastically changed in the second part of 2008, when frontier markets equities almost caught up with mainstream markets.
Despite recent market woes, experts mostly agree frontier markets could provide pension funds with interesting opportunities for portfolio diversification.
Hermes Equity Ownership Services, CEO, Colin Melvin, commented: “The opportunities for pension funds are huge. I think the anxiety investors have when investing in emerging economies is that it is relatively risky to do so. However, we firmly believe you can mitigate that risk by taking action as long term owners of a company and acting to improve broadly defined corporate governance to obtain more stable and more reliable investment returns.”
According to Melvin, corporate governance is perceived as the most concerning issue when approaching these areas of the world. In this respect, he warned pension funds: “Corporate governance is often narrowly defined as something referring only to codes and guidelines, but that’s a mistake. All aspects important to a long term owner of a company, like strategy and capital structure, need to be looked at, from a risk management point of view. Investors need to adapt to market’s local conditions.”
Ashmore’s Booth commented that while it had always been very risky to invest in frontier markets, risk had always been priced in. He added: “We could argue whether it has been priced in appropriately, but the real misperception of risk was rather in developed countries.”
During these months of crisis, excessive leverage has often been indicated as one of the determining factors of the market turmoil that engulfed the world economy. Banks and countries having high amounts of leverage have all been affected by the credit crunch or are vulnerable to it. On the other hand, those who did not have any leverage proved to be not vulnerable to the crisis. Countries without leverage may not grow faster than countries with leverage, but they do not pose any systemic risk.
Booth pointed out some frontier markets would be clearly in this group, with the disadvantage of being less liquid markets than the emerging or the mainstream ones.
While they could add diversification to a pension fund’s portfolio, he said opportunities were to be found in private equity transactions rather than public equity ones.
He said: “We would recommend either private equity type investments or in alternative specific companies – what we define as corporate high yield – where we would be financing through debt the growth capital of a company, either by taking a majority position or the entire position of the debt financing. Right now buying in public markets is less attractive in frontier markets.”
Adding to that, Hilden said there were markets which were totally ignored by foreign investors, but still offering good investment opportunities. He explained: “Let’s take as an example three countries close to each other like Vietnam, Cambodia and Thailand. Thailand these days could hardly be called a frontier market – it would rather be an emerging market – while Vietnam is a frontier market with a stock exchange and Cambodia is a frontier market without a stock exchange.
“I believe Thailand is the most interesting of the three, representing an ignored emerging market. Right now, it represents the same potential of upturn as the other two, but with less risk involved.”
He said he believed in opportunities in frontier markets, but that investors should be very conscious because those markets are very small, extremely volatile and very illiquid.
Hilden agreed with Booth that private equity type investments were the most interesting ones at this stage, but he also indicated real estate as an allocation to be seriously considered by pension funds in frontier markets.
He said: “There is a huge demand in these countries for offices, commercial buildings, housing and infrastructure. I think there are huge opportunities in these asset classes. Cambodia is the best example. There is no stock exchange there and I think that investing in the real economy of these countries can produce higher profits than the ones you’ll be able to make when they have a stock exchange.”
However, he concluded: “A pension fund should invest carefully, maybe 1% to 3% of the equity portfolio in these markets. The importance of these markets will grow in the future, but in the short term they don’t have the capacity to contribute very much to a pension fund’s portfolio.”
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