Investing in frontier markets

Broadly speaking, frontier markets look much like today’s emerging markets did 20 years ago. They are relatively undeveloped. Their economies tend to be dominated by domestically focused sectors such as banks, telecommunications and consumer companies whose prospects are shaped by local economic factors rather than global macro trends. And the lack of liquidity and available assets makes them hard to invest in, which, as a consequence, makes them under-researched.

Frontier markets used to be dominated by oil-intensive Middle Eastern countries. But as these were slowly absorbed into the emerging markets complex, the frontier markets universe increasingly became a grouping of low income, less developed countries with greater exposure to export-led development – though there are exceptions. For instance, Vietnam is one of the bigger success stories in the universe as it benefits from firms moving their manufacturing out of China.

Benchmark providers use different selection criteria and construction methodologies, which means there are significant discrepancies in frontier market equity and bond indices. For example, the FTSE Russel Frontier Index for equities includes 23 countries. In total, 44 countries are included in at least one of the frontier markets indices from MSCI, FTSE Russell, or S&P, and 15 countries overlap across all three providers. Given the limitations in frontier markets benchmarks, many investors are benchmark agnostic. 

Generally, however, African countries are particularly well represented in the frontier universe, including Nigeria, Ghana, Angola and Kenya. So too are former Soviet republics, such as Azerbaijan, Belarus, Georgia and Uzbekistan. There are a handful of Middle Eastern and South Asian economies such as Iraq, Jordan and Pakistan. Among notable Central and South American constituents are Costa Rica, Jamaica, Paraguay and Bolivia. And there are a few countries at China’s periphery, including Mongolia and Vietnam.

Fig. 1 - Many happy returns

10 years total returns, in dollars, rebased 17.02.2012=100

That frontier markets are unknown territory for most investors opens up the prospect of excess returns – for those who can devote the time and effort to understanding them (see Fig. 1). 

Predicting which frontier economies will be promoted into the emerging universe is one source of these returns. Upgrades drive market flows, and the year leading up to promotion tends to be accompanied by large positive returns for a frontier economy’s equity and bond markets. 

Fig. 2 - Containing risks

5- and 10-year risk-adjusted returns*

More fundamentally, these markets have a number of attractive characteristics. Unlike more traditional centres of productivity like China, Japan, the US and Europe, frontier markets have young and growing populations. This can potentially fuel growth, development and infrastructure spending.

At the same time, many of these countries are rich in natural resources, particularly sub-Saharan Africa, but also Latin America and parts of Eurasia. Inelastic supply, exacerbated by a push to carbon neutrality and underinvestment in new capacity, together with a rise in demand in the wake of the Covid pandemic have all helped to push up commodity prices. 

Technological advances, meanwhile can supercharge productivity gains. This is leading to improvements in commerce and the efficiency of market pricing in the wider economy – which is what happened across the developed world during the 20^th century.

In equities, company disclosure in frontier markets is more limited, and analyst coverage is much lower, than is typical in either developed or emerging markets. There also tends to be a large base of retail investors and lower institutional investor participation. The high share of retail participants is a source of bond and equity market volatility – these investors typically have shorter time horizons and can overreact to short term news flow. 

There are certainly challenges. In some of these markets, there are foreign ownership restrictions, the proportion of equity available to be traded is sometimes heavily restricted – there tends to be heavy state ownership in some of these economies – and in some locations there are significant operational hurdles to things like opening custody accounts. As a result, investors can find themselves with smaller holdings than they’d prefer and/or having to hold them for the long term.

At the same time, investors will often find they can’t avoid concentrating their investments by industry, given heavier weightings frontier markets tend to have in the likes of financials or capital-intensive industries, depending on how developed the economy in question is.

But returns tend to follow challenges. Frontier equity markets have generated at least as attractive risk-adjusted returns as emerging markets over the longer term. On a five year horizon they’ve broadly kept pace, while over the past decade they’ve significantly outperformed. Ten-year average annual return for frontier equities was 3.8 per cent against 3 per cent for emerging market equities, but once volatility is factored in, the risk adjusted return profile is roughly double (see Fig. 2).

Fig. 3 - Yielding

Frontier market sovereign bond yields, percentage points

In fixed income, frontier markets tend to offer high real yields, with hard currency sovereign bonds making up the bulk of the investible market. Bonds issued by frontier markets have yields twice those of emerging markets, although with lower credit ratings. There is typically low foreign buyer activity in these markets, and risks are very idiosyncratic. The markets are mainly dominated by countries with a history of regular issuance, and whose bonds carry a high political and macro-economic risk premium. But political events often lead to irrational price behaviour, and informed investors can profit from this volatility (see. Fig. 3).

Fig. 4 - Tempering risk in bond returns

Frontier bonds (JPM Nexgem) returns vs JPM EMBI, five year annual risk adjusted returns*

Frontier countries are making up an ever bigger proportion of the emerging markets bond universe – currently some 50 per cent of the JPM EMBI index in February 2022, up from 40 per cent a decade earlier. Issuance has grown thanks to deeper local financial markets and expanding local investor communities. The creation of liquid and tradeable foreign exchange markets not only allows foreign investors access to locally denominated investments, but also supports corporations’ international activities by allowing them to effectively hedge their currency exposures.

Fig. 5 - Zambia case study

Zambia spreads over US Treasury bonds, basis points

Frontier economies tend to be laggards across environmental, social and governance parameters, largely a function of their underdevelopment. But this also means they have the greatest scope for improvement through the issuance of sustainable bonds (which can act as policy anchors and transcend political cycles) as well as through investor engagement. Aligning ESG criteria with long-term structural drivers of sovereign credit-worthiness, such as improved governance and climate security, provides benefits to both investors and local populations.

Fig. 6 - Equity correlations

5-year correlations between MSCI frontier and MSCI EM equities indices with other equity indices

Like equities, frontier market bonds have performed well both in absolute terms and relative to emerging markets, with a broad spectrum of frontier countries providing significantly better 5-year risk-adjusted returns than the JPM EMBI benchmark emerging market bonds index. For instance, sovereign debt issued by Nigeria, Angola, Kenya, Jamaica, Azerbaijan, Costa Rica and Jordan has  generated at least double the 3.5 per cent annual average returns offered by the EMBI index (see Fig. 4).

It is typical for frontier bonds to trade at spreads of above 1000 basis points to US Treasuries when countries become distressed and experience increased investor fears of default. It is also common for these spreads to reverse direction rapidly once the government administrations engage with official lenders like the IMF, as occurred in Zambia during the past couple of years. So, for instance, spreads spiked with the start of the Covid pandemic in March 2020, again when Zambia defaulted on its debt in November of that year and then stabilised with the presidential elections in August 2021 (see Fig. 5). 

Fig. 7 - Bond correlations

5-year correlation to global bonds

The other key attraction is lower correlations between frontier markets and leading asset classes than emerging markets offer. This makes them a useful source of investment diversification. For instance, 10-year correlations between the return of the MSCI ACWI World Equities index and that of frontier market equities was 0.6, but 0.8 with emerging market economies (see Fig. 6). 

The story is similar in fixed income – the JPM Nexgem frontier markets bond index’s correlation was 0.18 with global bonds since 2019, compared to the JPM EMBI’s 0.34 correlation with global bonds (see Fig. 7).