Allan Conway of Schroders talks to Neal Underwood about the diversification benefits of frontier markets.
Q: You recently launched the Schroder ISF Frontier Markets Equity fund. What was the rationale for this?
A: The principle behind frontier markets is they are similar to emerging markets. They are countries going through a fast period of economic growth, which opens up opportunities for investment. These markets have always been interesting, but historically you couldn’t get in that early. People used to think emerging markets were the exotic idea; they now accept emerging is part of the mainstream. Frontier markets are the new emerging market. Many are much less developed, and there are structures where you can get exposure. It’s an opportunity to get into these markets at the earliest stage of development, which is likely to give premium returns.
This is nothing new for us. 60% of the MSCI Frontier Markets index is in the Middle East and we’ve got a dedicated team in Dubai and a three-year track record on the Schroder ISF Middle East fund – I’m running the fund alongside Rami Sidani, head of Middle East North Africa (Mena), who is based in Dubai. We have also invested in other markets, such as Kazakhstan, for some time. We also have exposure to Vietnam in our emerging markets funds. We already have exposure to quite a lot of these countries; it’s bringing all these together into one fund.
Frontier markets have a combined nominal gross domestic product (GDP) of $2.4 trillion (£1.5 trillion), which is 3.9% of global GDP. They also comprise 12% of the world’s population, of which almost 60% is under 30 years of age. Labour costs are extremely competitive and natural resources are abundant. The investment opportunities are excellent as frontier markets are under-owned, market liberalisation is accelerating and valuations are attractive.
Q: How much have you been able to draw on your emerging markets capabilities?
A: Massively. Groups running frontier markets funds tend to fall into two categories. Some are smaller boutiques, with a few people with possibly a good track record of scouring frontier markets for good ideas. We believe, however, you do need strong resources. We have 35 people running £27 billion in emerging markets. Those analysts have already been monitoring and looking at these countries. We’ve always been looking elsewhere at opportunities; we have a Qatari stock in our emerging markets fund which has been on our radar screen. We’ve been able to use those resources. If we only had a frontier fund it wouldn’t make economic sense; but we are able to utilise the process methodology and apply it to frontier markets. (article continues below)
Q: Are frontier markets less correlated to other markets and each other than, for example, larger emerging markets?
A: They are not very well correlated. Many are much more driven by what’s going on in their domestic markets; trends such as the movement of population. In Vietnam, for example, there are internal changes going on there. The only exception is Middle East countries, which are oil focused.
One of the advantages investors have going into frontier as part of a general portfolio is diversification. Rather than look through the list [of frontier markets] and say I like the look of that country – that would be very high risk – the way to get exposure is in a diversified way. We have strong risk controls, which give investors exposure and allow them to benefit from diversification.
Q: How do you define frontier markets?
A: It is anything in the MSCI Frontier Markets index. Why are they in there rather than emerging markets? It’s a question of how open they are for foreign investment, how easy it is to invest, how liquid they are. There is a divergence within frontier markets. Many have higher GDP per capita; it is not simply a matter of how rich countries are. But in the Middle East, for example, stockmarkets are underdeveloped.
Q: What are the characteristics which make frontier markets attractive?
A: For markets like Bangladesh and Pakistan, which are the more traditional frontier markets, they are in an embryonic period of rapid development. A function of getting involved at the early stages of development is you get premium returns. With others it is more a story of getting involved in stockmarkets as they start to reflect the importance of the economy.
The asset class generally is enormously attractive. Frontier is the new emerging. No longer are emerging markets high risk strategies; in terms of corporate governance many are up to the standard of Europe and the US. With frontier markets, though, there is higher political risk and you need diversification.
Q: Where are the real opportunities and are there any markets where you will not invest?
A: Very specifically we are overweight Kazakhstan, Saudi Arabia, Qatar, United Arab Emirates, Oman and Lebanon. Two of our biggest underweights are Pakistan, where we are worried about political instability, and Kuwait, where valuations are too high. You need people on the ground monitoring activities. Many of these countries have a dearth of research. You aren’t going to get the secondary coverage from brokers.
Q: How much of a problem is liquidity?
A: There is an issue there. We are in a minority of frontier markets funds that have daily dealing. That is unusual. What we are trying to do is focus on our investor base, making sure the right sort of investors are getting involved. It is a long-term story, and they should be in there on that view. We have generally been successful at getting investors in on that basis. The seed investors are institutional investors who came in on that basis.
Q: Should frontier markets form a part of all investors’ portfolios?
A: Absolutely. There is relatively low correlation so they are terrific diversifiers. With frontier markets you’re buying into the emerging markets story at an earlier stage. Adding in some exposure, albeit relatively small, to frontier markets is a nice diversifier. The mistake investors make is they think about each of these assets individually. They must go in for a diversified frontier fund and look at the way they interact together as assets. That will reduce risk and increase returns as part of an overall portfolio.