Investing Basics: Investing in frontier markets with investment trusts

 

Closed ended funds can help investors access the growth opportunity in developing economies…by David Kimberley

 
Emerging markets have grown from approximately 19% of the combined market capitalisation of global equities in 2009 to 26% in 2022 – a figure that investment bank Goldman Sachs estimates will rise to 35% by the end of this decade.

But whereas emerging markets have seen substantial growth over the past 10 to 20 years, frontier markets remain relatively untapped by institutional and private investors.

Research published by T Rowe Price in 2022 found that just 0.3% of global market capitalization was from companies listed in frontier markets, despite those countries constituting 15% of global GDP and 36% of the world’s population.

Frontier markets are countries which typically have smaller, less liquid stock markets than their emerging market peers. They also usually have stricter controls around foreign ownership and on capital flows.

Although they do tend to have smaller per capita incomes and be developing economies, that is not true across the board. For example, Iceland currently has one of the largest weightings in the MSCI Frontier Markets Index, despite being one of the wealthiest countries in the world on a GDP per capita basis.

As that implies, there isn’t a fixed definition for ‘frontier market’ and individual index providers will have their own criteria as to what constitutes one. Nonetheless, those criteria tend to be based on the features outlined above.
 

Why invest in frontier markets

 
Investing in frontier markets has typically been driven by investors looking for a mix of growth opportunities and equity exposure that is uncorrelated to their core investments.

That may sound straightforward superficially, but there are factors that are unique to frontier markets that support these features, which we look at in greater detail below.
 

• Information inefficiencies and alpha generation

 
Many companies in frontier markets receive little to no analyst coverage from institutional investors. Other sources of information also tend to be limited and equities are often difficult for foreign investors to access.

As a result, frontier markets tend to be less informationally efficient than more developed markets, meaning equity prices can be slower to reflect publicly available information.

This is positive from an investor’s point of view as it means there is, in theory, greater ability to exploit the pricing inefficiencies that dynamic creates and generate superior returns.
 

• Portfolio diversification

 
Diversification is another key driver for investment in frontier markets. Companies listed in frontier markets tend to derive more of their revenues from the domestic economy, meaning they are often less susceptible to global macroeconomic developments and more subject to the challenges the domestic economy is facing.

Listed companies are also less subject to fund flows as the amount of institutional exposure to frontier markets, whether in active funds or ETFs, is far smaller than in developed or emerging markets.

Frontier markets tend to display low correlation with developed markets because of these two factors and thus offer investors attractive diversification potential.

Indeed, research by the Investments and Wealth Association (IWA) published in 2018, found that frontier markets had a 0.43 correlation with the S&P 500. In contrast, emerging markets had a correlation of 0.63 and other developed markets had a correlation of 0.8.

The other diversification benefit frontier markets offer is that there is little correlation between frontier markets themselves. For example, that same research published by the IWA found that the correlation between countries in the MSCI Frontier Markets Index was just 0.2. The equivalent figure for emerging markets was double that at 0.4.
 

• Growth opportunities

 
The final key attraction that frontier markets offer is the ability to benefit from the growth of companies in smaller, faster growing economies.

For instance, Vietnam has the largest weighting in the major frontier market indices today. The country saw annualised GDP growth of 6.2% from 2000 to 2023.

As noted, frontier market companies tend to be more focused on domestic economies, meaning they are better placed to benefit from GDP growth of the kind that Vietnam has experienced. Moreover, they are typically starting from a smaller base, meaning there is wider scope for them to grow and deliver superior returns for shareholders.

Investing in frontier markets

Frontier markets tend to be defined by certain characteristics, like greater constraints on foreign ownership of companies and currency controls, which can make them difficult for investors to access.

For example, even for large institutions, moving money into and out of Vietnam or just buying and selling shares in the country is much more complicated than it would be in somewhere like the UK or US.

This means private investors are likely to find it extremely difficult to invest in frontier market equities by themselves. Indeed, none of the major investment platforms for private investors in the UK currently offers access to frontier market equities.

Aside from practical problems related to market access, it is also hard to evaluate investment opportunities in frontier markets due to the dearth of information available.

For example, a company may publish little information in English, have no analyst coverage from financial institutions and receive little coverage from other third-party sources of information, like a local media outlet or industry news sources.

The result is that private investors looking to invest in frontier markets on their own will have to overcome sizeable hurdles just to access those markets and, assuming those can even be overcome, they will then find it extremely difficult to find the information they need to evaluate prospective investments.
 

Investing in frontier markets using investment trusts

 
Investment trusts offer a simple way for investors to overcome these problems.

Investment trusts are funds that are listed as companies on the London Stock Exchange. Their shares can be bought and sold, meaning they are simple to access for individual investors.

More importantly, the fund management teams that manage investment trusts are able to overcome many of the hurdles that individuals face when investing in emerging or frontier markets.

That can mean navigating the bureaucracy needed to actually buy shares in a company, as well as managing things like currency risk that would be cumbersome and expensive for private investors to do themselves.

Moreover, as professional fund managers, they are able to access a deeper pool of resources in order to analyse equities listed in frontier markets.

That might mean the managers actually go to the country in question to visit company management and understand what they are doing. Similarly, they may also have access to local subject matter experts, who can help support the investment process.

These sorts of tools would be valuable in any market. For example, visiting and talking to company management with a UK firm would be a luxury that would be unlikely to be afforded to private investors.

However, you could argue that reporting requirements and a stronger corporate culture makes this less necessary in developed markets. Frontier markets often don’t have these strengths and so access to company management and country specialists becomes much more important.
 

 

Case study: BlackRock Frontiers (BRFI)

Company: BlackRock Frontiers

Launched: 2010

Manager: Sam Vecht, Emily Fletcher and Sudaif Niaz

Ongoing charges: 1.36%

Dividend policy: Aims to pay a dividend semi-annually

Benchmark: MSCI Emerging ex Selected Countries + Frontier Markets + Saudi Arabia Index (net total return, USD)

BlackRock Frontiers (BRFI) is currently the only investment trust listed on the London Stock Exchange that provides investors with dedicated exposure to frontier markets and smaller emerging markets. There is also no open-ended fund that invests in the same markets.

The trust was launched just over a decade ago in 2010 and is managed by Emily Fletcher, Sam Vecht, and Sudaif Niaz, the latter of whom was appointed portfolio manager in February 2023. The managers employ both top-down and bottom-up analyses when making their investments.

BRFI invests in a bespoke investment universe of the MSCI Emerging Markets and MSCI Frontier Markets Indices, minus the eight largest countries by market capitalisation (being Brazil, China, India, South Korea. Mexico, Russia, South Africa and Taiwan). Saudi Arabia is also in the investable universe, although it does not currently fit under either classification.

By excluding larger and more widely held equities and markets, the trust provides investors with a diversified portfolio that has lower correlation to developed markets. The smaller size companies also offer investors better growth potential.

1) What is the trust’s goal?

BRFI aims to achieve long-term capital growth by investing in companies that are listed in, or which derive the bulk of their revenue from, less developed countries.

2) What kind of stocks do the managers invest in?

The managers invest in companies that have strong balance sheets and are highly cash generative.

3) Are investments driven by a particular style?

BRFI’s investments aim to take advantage of the growth potential that frontier markets offer. Nonetheless, their focus on cash generative businesses also means they have a long track record of paying a dividend to trust shareholders.

Frontier markets tend to be more subject to macro risk compared to developed markets. As a result, the managers have to combine both top-down and bottom-up analysis when making their investments.

With regard to the former, the managers use a proprietary dashboard to monitor factors like liquidity, currency, and political risk. If these factors pose significant risks then the managers will not invest, regardless of how attractive a company’s fundamentals might be.

4) How many companies does the trust normally hold?

BRFI’s managers do not hold a ‘normal’ number of companies but are diversified across regions and sectors. Frontier markets are less correlated with one another than larger markets, which aids this process.

5) What is the trust’s dividend policy?

The trust does not have a specific dividend target, but pays out a semi-annual dividend. The dividend yield as at 30/06/2023 was 4.3%.

6) What are the trust’s ongoing charges?

1.36% as at 30/06/2023

7) Does the trust have a performance fee?

The trust has a performance fee equal to 10% of any NAV outperformance relative to the benchmark cumulative benchmark returns since inception. This fee is capped at 2.5% of NAV if absolute returns are positive or 1% if that’s not the case.

8) How much attention do the managers pay to their benchmark, and to what extent are absolute returns important?

BRFI uses a bespoke benchmark index, which they deviate from markedly on both a sectoral and country allocation basis. Although the managers can and do use derivatives to take short positions in the market, this is not an absolute returns strategy. The maximum permissible exposure to short positions is 10% of net assets.

9) Does the trust use gearing? Is it structural or opportunity-led?

BRFI does use gearing. This is opportunity-led and is typically achieved by buying or selling contracts for difference (‘CFDs’). The managers take both short and long positions in the market using derivatives.