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A new frontier

An increasing number of investors are turning to countries such as Vietnam, Pakistan and Nigeria for returns they can no longer get in the usual go-to emerging markets.

By: VIKRAM BARHAT

Date: December 28, 2015

Over the last decade, investors have flocked to fast-growing emerging markets to get some additional portfolio growth. As these nations have become larger and more integrated into the global economy, though, their ability to provide above-average growth has diminished.

However, there is another part of the world that’s providing the same kinds of opportunities that the emerging economies once did: the frontier markets.

These markets, which include countries like Nigeria, Vietnam, Romania and Oman, are widely regarded as a subset of emerging markets, only with smaller size, faster growth and a higher risk profile. Many money managers insist, though, that some of these markets are worth a look.

Fast-growing economies

One of the more compelling arguments for investing in these up-and-coming economies is that all emerging markets were once frontier markets before they grew and moved up the food chain.

And, like their larger counterparts, frontier markets are characterized by robust economic growth, younger demographics, an improving socio-political environment and greater domestic consumption.

“Emerging markets today have a very different risk-reward backdrop than most of us remember from 20 years ago,” says Adam Kutas, a Portfolio Manager with Fidelity Investment who will be managing the Fidelity Frontier Emerging Markets Fund. “Frontier markets are more early-stage economies: faster-growing, and a lot less discovered and understood.”

Mr. Kutas likens frontier markets to small-cap stocks in terms of growth and volatility profile, whereas emerging and developed economies would represent mid-cap and large-cap stocks, respectively.

Why would an advisor consider allocating their clients’ capital to relatively unfamiliar geographic regions with seemingly high headline risk? Because you can’t find these kinds of markets anywhere else.

“Frontier markets have younger, faster-growing, urbanizing populations with low levels of leverage,” says Mr. Kutas. “This should provide a backdrop for uncorrelated structural growth, which would be more difficult to find in emerging and developed markets.”

Diversification benefits

Another reason to consider frontier markets is for diversification benefits. Geoffrey Adams, senior vice-president at Montreal-based advisory firm Sherbrooke Street Capital, says frontier markets don’t behave the same way as emerging markets.

“A rational investor would put frontier markets in their portfolio because, in most cases, they don’t act like other things in their portfolio,” he says. “These markets do well, or don’t do well, because of what’s going on in their own backyard, not because of their interconnectedness to global markets.”

Not only are frontier markets not highly correlated to developed or emerging markets, they’re also not necessarily correlated to one another, says Mr. Adams.

Manufacturing centres

As future growth engines of the global economy, frontier markets are experiencing a boom in production and equity performance. Many of these markets have become manufacturing bases for international companies looking for smaller, people-rich countries with inexpensive labour.

That’s one of the reasons why frontier markets can generate between 10 per cent and 40 per cent higher equity returns than those found in emerging markets, says Mr. Kutas.

“Look at imports of light manufactured goods that we buy at Canadian Tire or Walmart,” he says. “Ten years ago, a lot of that was made in China, but manufacturing is now moving to countries like Vietnam, Pakistan, Bangladesh and Cambodia, primarily due to cheaper labour costs.”

The trend is further fuelled by China’s policy to move up the value curve and into higher-end product sectors like robotics and aerospace, he adds.

Neighbouring Vietnam, now the world’s largest manufacturer of mobile phones, is arguably one of the biggest beneficiaries of China’s policy shift. The East Asian nation is pulling out all the stops to attract foreign investors.

“Their government policies are moving in the right direction, as they recently removed foreign-ownership limits, going from [a ceiling of] 49 per cent to 100 per cent in most sectors,” says Mr. Kutas. “Companies are pretty cheap, at about 11 times earnings for more than 20 per cent returns on equity.”

He also likes Romania and Pakistan for their ongoing privatization, lower stock valuations and reasonable upside potential.

Rapid growth in consumer-staples demand is another important theme in the vast majority of frontier markets, says Mr. Kutas. Many countries are seeing a rise in retail that’s proving to be positive for producers of basic foods, like beverages, cookies, and crackers.

A small part of your portfolio

As for their place in the overall investment pie, Mr. Kutas suggests that these countries should account for no more than 10 per cent of a portfolio.

“They shouldn’t be the core part, but they can provide impact and, hopefully, risk-adjusted returns,” he says.

However, before buying in, make sure you understand the risks involved. These markets are often volatile, and the swings can be large, says Mr. Adams.

That’s why diversification within the frontier markets is important. ”They will be less volatile if you avoid zeroing in on one specific region of the world,” he says.

Frontier economies also have high levels of government involvement, and can rise and fall based on political issues, says Mr. Kutas.

That being said, these markets are an effective way to gain fast-growing emerging-market-like exposure. For investors with some risk tolerance, the frontier could provide both sector and geographic diversification as well as handsome long-term returns.

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An increasing number of investors are turning to countries such as Vietnam, Pakistan and Nigeria for returns they can no longer get in the usual go-to emerging markets.

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