Frontier Markets: A Refuge For ‘burning’ Investors?

IT is almost a year now since the onset of the global stock markets “bloodshed” and investors are increasingly looking to frontier markets for cover.


These markets have long been considered no-go areas for international investors but, thanks to the tailspin on both emerging and developed markets, many are turning to them. Whether this signifies a change of heart or is a short term measure expected to last until the dust in other markets settles, remains unclear. In the interim though, the “frontiers” will play host to the restless investors which should continue to drive share prices up, before the downturn eventually reaches them.

“Frontiers” are small, less accessible but investable markets that are generally considered to be at an earlier stage of economic development. They can have as few as 15 listed stocks with total market capitalisation as small as US$1 billion. Because of their size, the frontiers tend to be illiquid such that a transaction of, say, US$10 million can take a week to execute. They exist at the periphery of the emerging markets in places such as sub-Saharan Africa, South Asia, Eastern Europe and the Caribbean. The Zimbabwe Stock Exchange (ZSE) falls in this group.

They differ from emerging markets which are countries that are experiencing rapid industrialisation, have adopted market capitalism and are showing great potential as good investment areas. The countries in this category include South Africa, India, Brazil, Russia and China among others. Over the years these countries’ stock markets have evolved and now exhibits close relationships with the developed world.

The recent heightened interest on the frontiers is to a greater extent because of their low correlation with the developed markets. There is less, if any, relationship between them and the emerging markets, and even among themselves. Each market is unique. For instance, the ZSE was not affected by 9/11 World Trade Centre attacks and recently the global credit crisis escaped unnoticed on the local bourse. (A different school of thought, however, attributes the isolation of the Zimbabwe from the world markets to exchange control which impacts directly on income and capital flows especially in an outward direction.)

In the low tier markets, stocks move in ways that make little sense to outsiders. Investors on the markets respond to a host of issues such as hyperinflation, power outages, political uprisings and even floods. Frontiers behave in a manner alien to international investors because they are decoupled from global markets. Rising inflation, for instance, prompts selling on the US stock market while on the ZSE investors pile into equities as a hedging mechanism against hyperinflation.

To many foreign investors who thrive on value investing, charting and sophisticated valuations, frontiers are not an option. Risk seeking individuals and institutions such as hedge funds and private equity firms make up the majority of investors showing interest in undeveloped markets. Zimbabwe has seen a number of these interested suitors recently with reports that even more have a soft spot for the country’s assets.

The drawbacks of frontier markets to prospective foreign investors include lack of information, inadequate regulation, non-transparency, substandard reporting and illiquidity of shares. Their other shortcoming is the inability to transfer profit. One would argue that these risks are adequately compensated by abnormal returns obtained in these markets.

Over the past five years, frontier markets have outperformed both emerging and developed markets, according to the numbers released by the Standard and Poor’s. The S&P/IFC Frontier Index, an index which measures performance of 37 frontiers, returned an average of 37% per annum over the past five years. During the same period the MSCI Emerging markets index returned 25% per year. The Frontier Index return was almost five times the total return achieved by the Standard & Poor’s 500-stock index which measures performance of top US companies.

The “frontier effect” is also noticeable on the ZSE albeit to marginal extent because of the economic depression. A number of foreign institutions have expressed interest in local assets. Renaissance Capital and LonZim recently invested in ZSE companies. The local bourse returned about 60% in 2007 to end the year at US$5 billion.

In June 2008, the ZSE posted its highest ever monthly growth of 15 034% despite high political uncertainty. This represented real growth above the parallel and interbank rates which returned 6 900% and 1 897% correspondingly.

However, the Old Mutual Implied Rate (OMIR) was ahead of the industrials as it grew by 20 937%. The price of Old Mutual on ZSE was firm while in London (LSE) it went down by 21% to 90 pence. The slump in price was in tandem with the general bearish sentiment on major exchanges in June which saw the FTSE 100 losing 7% while the Nasdaq and Dow Jones industrial average retreating by 9% and 10% respectively.

The accumulation of capital in the developed world is driving down returns in these areas leaving investors to look to peripheral markets for high returns. But this involves increasing risk. Moreover there is no certainty that average returns will rise.

The Middle East has long been seen as a potentially lucrative area to invest but political and economic tensions, precisely because of their oil resources, make many fund managers nervous.

India and China are obviously less risky but growth and change in their domestic economies can be expected to exacerbated domestic tensions and promote heightened international rivalry.

By Rangai Makwata