Frontier Markets: Fertile Ground for Active Management

To rebrand what had been referred to as the “third world” into more aspirational terms, the World Bank notably established the term “emerging markets” (EM) in 1981. The composition of emerging markets has changed dramatically since then, driven by the incredible growth in China and to a lesser extent India, Brazil, Korea, and Taiwan.  

Yet, the legacy of describing EM as a homogeneous entity to be contrasted with “developed markets” has been surprisingly resilient.  

Each country that falls under the EM umbrella in fact has its own growth story, risk profile, and relationship with the global economy. With democracies in decline across much of the developing and developed world, and many countries demonstrating an inability to get out of their own way, it’s imperative for investors seeking international diversification to employ a strategy that has: 

1. a strict set of criteria for investability 

1. a focus on investments that are primarily tied to local growth trends, rather than global macroeconomic dynamics.  

Too Big to Remain in the Shadows 

A portion of the EM universe, Frontier Markets represent a meaningful share of the world’s population and are a significant contributor to global GDP growth. They continue, however, to lie in the shadows of larger emerging markets which, in our view, are far from “emerging.” 

Demographics are the key source of growth in Frontier Markets: populations are urbanizing, becoming more skilled, and are significantly younger than the rest of the world. To varying degrees of success, many Frontier Market countries have been transitioning away from commodity- and export-driven dependencies towards service-oriented economies.  

Nonetheless, current valuations and a relatively small share of capital markets strongly suggest investors are overlooking Frontier and smaller Emerging Markets, also referred to as FEM, which is an attractive opportunity set.  

Frontier Market Risk Misunderstood 

Widespread geopolitical upheaval and a global pandemic that disproportionately impacted the Global South have reinforced the misconception that Frontier Market equities are, by definition, riskier than equities domiciled in larger EM countries.   

While indeed, one can argue that any individual FEM country, when compared to any of the large EM countries, is inherently “riskier” due to its less developed capital markets, legal system, and regulatory infrastructure. This isn’t necessarily the case in the context of constructing a diversified portfolio.  

An institutional manager with existing exposure to US and European equities world will simply not achieve the same diversification benefits from an EM fund or ETF dominated by TSMC, Samsung, and a handful of other companies with global footprints as they would from adding a curated basket of EM equities from select Frontier markets. Each stock with its own idiosyncratic and locally driven risk profile.  

Active Management is Essential in EM 

To their detriment, investors have strongly favored gaining exposure to EM through passive vehicles that are highly concentrated in large EM countries and indiscriminate about which countries are investable.  

Both larger EM ETFs and Frontier ETFs (the most dangerous of the lot) are required to maintain a high level of fidelity to their index. As a result, such investment vehicles are often unable to avoid investing in a particular country no matter how egregious its political failings or inability to meet the basic needs of its people may be.  

The Frontier and Select EM ETF run by BlackRock’s iShares unit is a case in point. In April 2023, the money manager announced it would be an actively managed investment, no longer tied to the MSCI Frontier and Emerging Markets Select Index. Subsequently, the manager essentially suspended new investments in Bangladesh, Egypt, Kenya, and Nigeria due to potential difficulties getting cash out of the countries. This occurred nearly a year after active managers like us were able identify red flags and comfortably find the exit doors.  

Being nimble in our ability to consistently anticipate deteriorating conditions in countries within the Frontier Market universe has been critical in the solid long-term performance of our Frontier Market equity strategy. 
 

It also reflects our belief that perhaps the most important lesson we’ve learned in decades of investing in Frontier and Emerging Markets is that hope is not an investment strategy.  

With an increasing number of nations being driven by bad economic policy sets with no prospect of recovery, focus and discrimination are more important than ever. To the benefit of our investors, in recent years we’ve become more stringent about our minimum criteria for investing at the country level.  

Disciplined Thinking Essential 

We contend that to find value in FEM, it’s essential to invest with active managers who are willing to make the seemingly aggressive decision not to invest in a country with a high representation in an index. Managers must, of course, also be willing to invest in a country no matter how low its representation. 

Admittedly, we’ve made some mistakes alongside our successes over the years, with respect to country selection. But such experiences have also sharpened and refined our increasingly disciplined approach to FEM investing.