Gritting Out the FM and EM Investing Friction
For those unaccustomed to investing in Frontier and Emerging Markets, it can feel like a complex corner of the financial world.
That’s because it is.
It’s not as simple as snapping your fingers, saying “Pakistan looks good today,” opening an account, and promptly taking advantage of whatever opportunity caught your eye.
Not tomorrow or next week. It’s just not going to happen that fast.
Even in the best scenarios, it takes three months to open the necessary accounts, clear the regulatory hurdles, complete the documents that the consulate requires, and be properly ready to trade.
Domestic markets just don’t have that same level of friction, because there’s not as many people touching it. And that necessarily makes FEM transactions more expensive than trades made in U.S. markets.
But the challenges can be overcome, especially with an experienced and thoughtful specialist who understands what obstacles exist and how to deal with them efficiently.
Both Sides of the Coin
Simply put, there’s no rule of thumb when looking at the mechanics behind Frontier and Emerging Markets investing. It’s a country-specific landscape with each market having its own complex market matrix and related risks.
For example, India was essentially closed to external investors for years, with all sorts of barriers to entry. While currently more open, it remains challenging as they still have hoops such as needing to retain a local tax accountant so you can remit local capital gains taxes.
Nigeria is also tough as it has all sorts of controls on the exchange rate on its currency, the naira, as external investors work to get their funds in and out of the country.
Alternatively, a country can have tough restrictions in place, like Vietnam, but there are ways around them. Officials there set limits on foreign ownership of stocks, but they’ve still been able to attract a lot of foreign capital.
Meanwhile, Chile is an essentially fully open country to invest in at this stage—it’s virtually first world in that aspect. Similarly, South Korea runs a fairly open exchange, but you would hope so with all of the big, globally competitive companies there.
The countries that are easier to get in and out of—or are more willing to look past restrictions—have realized attracting foreign capital is to their benefit. And if they want their companies to have proper international valuations reflected in their stock price, they’re going to have to allow foreign investors to come in and help price them. And that will provide better returns for local investors.
Why don’t some countries do that versus others?
Frankly, some may be running bad macroeconomic policies and don’t want to run the risk of their foreign exchange reserves being drained.
Ultimately, it’s not necessarily the structures that inhibit stock performance, and many markets have still been able to attract a lot of foreign capital. But potential stock returns come back to:
- Is it a good country to invest in?
- Do they have good companies to invest in?
- Is it a good company to buy?
If all looks good, and the macro scenario is right, the frictional issues about getting in and out are more easily absorbed.
The Bigs Aren’t Immune
Many investors working through a large broker shrug off the in-country risk, assuming their exposure is limited to the multinational with retail branches across the U.S.
They’re wrong. And they probably don’t know the true scope of the risk they’re taking.
The bigs are almost always working as agents, not principals, in far-flung countries and they don’t have seats on local exchanges.
Consider that every investment management working internationally has gone through the exercise of canceling trades when people don’t disclose that they’re acting as agents but there’s suddenly a confirmation that indicates just that. Who’s this broker being used as a local agent? More than likely, it’s not Morgan Stanley or some other multinational.
The tangible aspects of taking the local agent risk: How do I know I’m going to get my stock certificate? What’s happening to my money? What’s the chain of custody?
Elevated Commissions a Given
Probably the largest issue compared to investing domestically or in other developed markets is commission rates. They’re still comparatively high, and that applies whether you’re going through an ETF or directly into the countries.
It may not be obvious as they’re frequently obscured—the commission may be tied up in an ETF’s fee embedded in a stock trading for 3 cents a share on the NASDAQ—but it happens on a regular basis.
For many investors, that’s still a bitter pill to swallow. For example, an institutional investor in the U.S. so focused on expenses will struggle with this cost of diversification and the return on investment for that diversification.
Our Approach
The big brokerages have a limited amount of clout in these small, developing nations—they can flex their muscle, but they rarely have any kind of legal footing to go after someone if something goes wrong. And yet, its usually such a small part of their business that they don’t commit much to ensuring things go right.
Our approach at Consilium, conversely, is to approach each distinct market carefully and thoughtfully.
Over decades of working in the FEM space, we’ve learned that we must examine:
- All counterparties, including the custodians, local brokerages, and stock exchanges
- The currency exchange and the pricing they’re providing
- The global custodian interfacing with the local custodian
- The taxes that must be paid—and the correct way to get that done
- All commissions and fees—ensuring the negotiation of those is efficient
Digging deeper, we run a credit analysis on every broker that we must use as a counterparty, analyzing the strength of the broker, the strength of the system, and how it actually works and flows. So, when we put money into a country, we know when:
- The funds are distributed
- The funds hit our global custodian
- The funds get transferred to the local custodian
- The funds get converted into the local currency
- The delivery is completed, relative to the payment
If there’s any mismatch, we know whose ultimate risk we’re taking for our settlement.
We run those audits annually, and while things usually don’t change much, you don’t know where the war is going to break out, where the sanctions are going to arise, or whether you’re going to get caught mid-trade somewhere and not be able to sell your position.
And who runs those credit writeups on the counterparties for our firms?
Our analysts.
They may view it as overkill—so many of the steps in a trade have been streamlined for years—but this exercise helps them remember what actually goes into buying and selling a stock.
Plus, people make mistakes along the way and yes, there will be people in the chain who are self-dealing and not disclosing it. It doesn’t matter if it’s electronic, it’s still a financial instrument, and that goes back to the days where it was a physical piece of paper.
To counter the FEM friction, your primary protection is to do your homework and try to ensure that the basics are not being overlooked. That helps ensure that you don’t let control over your cash pass into the wrong people’s hands prior to actually possessing the security.
| Although many investment managers have pulled back from Frontier and Emerging Markets, our continued exploration of the space is bolstered by our firm’s expertise, which co-founder Jonathan Binder sheds a light on in A Globetrotter’s Take on FEM Investing. | 
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