The real story of how Kenya became a net importer of wheat in recent years is a complicated one, but the story people like to tell is easy: All the Kenyan farmers have shifted to making barley because brewers are paying higher prices for what makes beer. "People would rather drink than eat," said Larry Speidell, chief investment officer at Frontier Market Asset Management.
Speidell was only half serious—but it's an anecdote with an element of truth.
As consumers in developing countries generate more disposable income and move up into the middle class, consumer-linked industries are playing a greater role in markets. The frontier markets in Africa are no longer limited to the national banks and volatile natural resources bets with which they are most often associated, and that's increased the attractiveness of the frontier as part of a long-term global stock diversification.
"This is not just for the elite," said Julie Dickson, equities portfolio manager at Ashmore. "Frontier markets is what emerging markets was 20 years ago."
In Africa, finance and energy still dominate, but consumer-related sectors are why many professional investors are bullish on the frontier markets story over the long term. Sara Shores, iShares managing director, noted that a handful of the biggest companies in Africa are beer companies and that the broadening of frontier market investments and the diversification the asset class offers isn't just an African story.
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"The consumer story in Africa is strong, and it's not just Nigeria," Dickson said. "The consumer theme has been one of the fastest-growing consumer markets in the world, and there is no reason why that should not continue."
The only non-correlated asset class?
Year-to-date, the iShares MSCI EAFE Index Fund is down more than 7 percent; iShares MSCI Emerging Markets Index Fund is down 1 percent. The iShares MSCI Frontier 100 is up 15 percent, according to ETF.com data, extending a frontier market rally from 2013 that even many frontier bulls expected to moderate. Still, the right way to think about frontier investing is not as a market-timing bet, but as a component in a long-term global equities diversification plan.
Foreign-stock category correlations with S&P 500
(Three-year period through Sept. 2014)
- EAFE: 0.82
- EM: 0.74
- Frontier: 0.64
R-squared measure for foreign-stock categories
(R-squared is a statistical measure that represents how much of a security's movements can be explained by movement in the S&P 500 Index, with 1 representing perfect correlation.)
- EAFE: 0.68
- EM: 0.55
- Frontier: 0.41
Shores said the average cross-country correlation in the frontier markets is 0.3, which is important, because it runs counterintuitive to the idea that the frontier is inherently more risky than developed markets. "A Nigeria brewery is not very correlated with Vietnamese milk or an Estonian ferry company," Shores said. "The frontier is the outlier among equity markets, not levered to the global finance cycle."
Everyone should look at the frontier. No one can pretend to know enough about any company to really put a huge weighting in a single stock there, but think about population. More than 1 billion people live in frontier countries. That's 1 out of every 5 people on the planet.Larry Speidellchief investment officer, Frontier Market Asset Management
For Jonathan Neill, a portfolio manager at Fabien Pictet Partners who specializes in emerging markets, there is something to be said in the defense of the frontier as a non-correlated asset class. "The financial crisis and banking crisis was not a feature of African economies," Neill said. "They laugh when Westerners say they need to go teach them how to run banking systems."
But for Neill, right now at least, there is more to be said against the frontier than in support of more investment. For one, that non-correlation story has been coming down over time as more investors recognize the frontier. He also thinks the great rush to the frontier is over, for now, and markets in Africa, in particular, have become expensive. Indeed, the Nigerian market is down over 8 percent this year. "I don't think the frontier offers much opportunity anymore. I'm much more bullish on emerging markets now from a valuation point of view," Neill said, noting that he has an 18-month minimum outlook.
Neill said that the frontier story being marketed to investors is in need of a few correctives. For one, valuation trumps demographics. "There may very well be good bets in frontier countries like Nigeria, but it's what you pay for it," Neill said. "The emergence of the middle class in Country X, or working class—these are gimmicks, just marketing stories for fund managers. What matters is valuation."
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Dickson said that as the frontier investment theme has caught on, some African investments have become expensive, but investors still need to take a long-term view.
Speidell didn't disagree with the valuation risk, either, especial for consumer stocks in Africa and African banks, but said it's a subset of the frontier story. "There are large-cap stocks in the consumer space that have been overbought, and that's part of the theme of a rising middle class and what they will buy," Speidell said, adding that he has watched price-to-earnings ratios in some frontier market consumer companies, such as food and cosmetics, increase significantly over the past six to seven years.
But he added, "There's plenty of frontier outside of Africa." He has recently been to Sri Lanka, Bangladesh and Vietnam, markets he considers to be key parts of the frontier story. Speidell's firm has 40 percent of its frontier bets in Africa, 15 to 20 percent in Asia, 15 to 20 percent in Eastern Europe, and smaller bets in regions including Central America. Frontier Market Asset Management holds 65 to 75 frontier market stocks across 30 countries.
One challenge for retail investors looking to invest in the frontier within a low-cost index strategy is the paucity of options and the concentrated bets those index funds have taken.
The iShares MSCI Frontier 100 and the Guggenheim Frontier Markets ETF are the only two broad index ETFs, and they are very different. While the iShares ETF is up 15 percent this year, the Guggenheim ETF is flat. Why?
Even with heavy exposure to a down Nigerian market, the iShares ETF is highly exposed to the Middle East—which has been the best-performing frontier market. Kuwait represents 24 percent of the ETF, and Qatar, Oman and United Arab Emirates a combined 17 percent. Meanwhile, the Guggenheim ETF has 40 percent of its exposure to Chile, 17 percent of its exposure to Colombia, and 14 percent of its exposure to Argentina.
"Do you want 24 percent of your portfolio in Kuwait? I don't want 24 percent of anything," Neill said.
Another issue for the iShares ETF is the ongoing removal of Qatar and the United Arab Emirates from the fund, which have been bumped up by MSCI to its emerging markets index, the first two frontier countries to make the jump. By November, a six-month reduction of exposure to these two Middle East countries is expected to be completed by iShares. The ETF tracks 100 stocks and no two countries can comprise more than 40 percent of the ETF, according to its investment objective. Kuwait and Nigeria currently represent 38 percent of the ETF.
A limited frontier
The frontier experts agreed that for any investor, frontier markets should represent a very small piece of a global portfolio. Ashmore's Dickson said that for knowledgeable investors, that might run as high as 5 percent to 10 percent, but other frontier experts, including Shores, said that for most investors, it means 1 percent to 2 percent of a market cap-weighted portfolio exposed to the frontier. "This is not needle moving, but a way to get more return potential from emerging markets. It is the next generation of emerging markets," Shores said.
Speidell said if 10 percent of the global emerging markets valuation is frontier markets, then an investor can use that as a guideline: If you have 20 percent of your portfolio in emerging markets, have 2 percent in the frontier; if you have 10 percent in emerging markets, have 1 percent in frontier markets.
Of the 7.1 billion people on Earth, 1.44 billion live in frontier countries that have stock markets; another 750 million live in less-developed countries that do not yet have stock markets.
"Everyone should look at the frontier," Speidell said. "No one can pretend to know enough about any company to really put a huge weighting in a single stock there, but think about population. More than 1 billion people live in frontier countries. That's 1 out of every 5 people on the planet. I live, drink, eat, breathe the frontier."
Performance on the frontier
- WisdomTree Middle East Dividend: 25.8 percent
- Market Vectors Gulf States: 24.6 percent
- Market Vectors Vietnam: 17.8 percent
- iShares MSCI Frontier 100: 15 percent
- Global X MSCI Argentina: 1.4 percent
- Guggenheim Frontier Markets: -0.7 percent
- Global X Central Asia & Mongolia: -3.7 percent
- Global X MSCI Nigeria: -8.4 percent
Where the frontier money flows
- iShares MSCI Frontier 100: $798 million
- Market Vectors Vietnam: $600 million
- Guggenheim Frontier Markets: $87 million
- WisdomTree Middle East Dividend: $58 million
- Market Vectors Gulf States: $27 million
- Global X MSCI Argentina: $23 million
- Global X MSCI Nigeria: $20 million
- Global X Central Asia & Mongolia:$2.6 million
(Year-to-date performance and total assets through Oct. 7; Source: ETF.com)