Since the emergence of “Modern Portfolio Theory” and the “Capital Asset Pricing Model” in the late 1960s, institutional investors have taken a quantitatively driven approach to portfolio construction, looking to create portfolio diversification and obtain better risk-adjusted returns by balancing their asset-class exposures. This journey has seen several important advancements in thinking about how to optimally achieve desired results.
Funds that want to take the total portfolio approach first need to get the total portfolio view. To do that they not only need data – and lots of it – but a rock-solid understanding of exactly how they’re going to use it.
Why it’s time for frontier markets
Big Australian investors have never been very fond of taking geographical bets in their portfolios. Just ask a marketing person about selling Asia ex-Japan, for instance; even in the ‘Asian Century’.
There are good reasons for why they shouldn’t, the main one being that geographies limit an investor’s universe. A good investment is a good investment. You may have to adjust a risk profile for different jurisdictions with different types of governments and rules, but they can be calculated into a price. There have been times, though, when investors have dabbled, conscious of the changing fortunes of various regions and the nagging concerns about a home-country bias.
Australian investors, it should be noted, have the most extreme home-country bias of any group. A standard 30-35 per cent allocation to Australian equities, and 70-80 per cent to Australia in total across all the asset classes, is a lot for a market that makes up just 2 per cent of the world.
We can blame our tax system and fears of currency movements for the bias, but one wonders whether there are other factors in play.
Extreme valuations in some sectors, such as technology, have occasionally prompted a serious rethink. During the tech boom of the late 1990s and, quite possibly, in the current climate/sustainability/ESG boom it is tempting to look at countries and regions which are benefitting most. With tech it was the US and with climate and sustainability it is Europe.
The ‘Asian Century’ has not yet delivered extreme valuations and even Australian super funds, with all their knowledge of China in particular, are loath to offer Asia-ex mandates, let alone single China mandates. To generalise terribly, an emerging markets mandate is about as far as they will go.
However, big funds have shown a healthy appetite for alternatives in general, especially infrastructure and, more recently, private markets including credit. Why not an alternative based on regional selection which also offers up low correlations and the possibility of alpha from stock selection?
Ali Hussain, a frontier equities market specialist with FIM Partners (which stands for ‘frontier investment managers’), has written a paper contrasting the characteristics and performance of frontier markets and emerging markets.
Hussain, the Dubai-based head of research for FIM, joined the firm in 2014 to help develop the frontier equities strategy after it had already built a track record with a successful MENA (Middle East and North Africa) strategy since 2008. FIM is half-owned by the listed investment bank EFG Hermes and half by staff.
The paper, ‘Frontier Equities – the Undiscovered GEM‘, analyses what Hussain refers to the ‘dichotomy’ for investors posed by frontier markets in general. They represent some of the fastest growing economies in the world, with a uniquely youthful population base. But they have underperformed the emerging markets index for most of the past decade.
Hussain says the underperformance is misleading, stemming mainly from shortcomings in index construction. And, in FIM’s case at least, dating back to inception in 2013, frontier markets offer more fertile ground for active managers to add alpha with their stock selection.
FIM’s strategy, under the ‘Frontier Fund’ banner, has delivered an annualised gross return of 13 per cent since January 2013 until July 2021. This compares with the MSCI’s Frontier Emerging Markets index return of 1.3 per cent, and the MSCI Emerging Markets index return of 4.7 per cent over the same period. For broader comparisons, the MSCI ACWI ex-USA has returned an annual 6.5 per cent and the standard MSCI ACWI, 9.2 per cent.
In his paper, Hussain says: “Relative to EM, the sectoral concentration and lower diversity of the FM index does not provide the opportunity to express high growth secular stories reflective of the economic transformation and demographic attributes that define these markets i.e., structural reforms, behavioural evolution (traditional to modern retail, durable goods ownership), and more recently the digitization boom at the hands of these young tech savvy populations, to name a few.
“Recognising these drawbacks, a benchmark agnostic approach can deliver superior returns. For example, we assess investment opportunities based on the power of the secular themes they represent and liquidity thresholds (in line with our capacity ceiling & risk guidelines) rather than index membership, creating a broader and more diverse investment universe.”
The top sector weights for the frontier equities index are: banks (30 per cent), real estate (13 per cent), capital goods (12 per cent), materials (9 per cent) and telecoms (8 per cent). For the emerging markets index the top weights are: banks (13 per cent), retailing (11 per cent), semi-conductors and equipment (9 per cent), technology and hardware (9 per cent) and media and entertainment (9 per cent).
Both indices overlap to a certain extent. For instance, leading frontier markets, as defined by MSCI, which are also in the emerging markets index include Pakistan, the Philippines, Indonesia and Egypt.
But the EM index is highly concentrated, with the top seven countries having a combined weight of 85 per cent. This means that accessing a frontier exposure through a benchmark-aware EM mandate is unhelpful. A global EM indexed mandate would have an exposure of only 2 per cent to frontier equities.
The largest emerging markets returns are much more highly correlated to the MSCI World Index than the top 10-11 frontier markets are on both counts.
And then, the paper points out, there is timing. Hussain believes that frontier markets are like emerging markets were 20-30 years ago. There are some current themes which make a lot of sense from a top-down point of view. Digitisation is a major theme right now.
The paper says: “As early as five years ago, the FM investment case was predominantly about monetising old economy themes stemming from the changing consumption habits of these young urbanizing populations. While most of these historical themes will continue offer superior growth rates to large EMs in the medium term, the FM investment case has recently evolved with the rapid proliferation of digitization…
“Despite favourable demographic attributes conducive to technology adoption, the FM tech space has emerged much later than its peers primarily due to lack of access… At the same time, lower disposable incomes initially restricted smartphone adoption levels. But rapidly falling smartphone prices combined with increasing 4-G coverage has led to a rapid increase in smartphone adoption levels.”
Across tech verticals, such as e-commerce, fintech and digital lifestyle apps, frontier market adoption rates are growing exponentially from a much lower penetration rate. Compared with China’s retail sector penetration rate of about 35 per cent in e-commerce, Vietnam and the Philippines are only 4-5 per cent and Bangladesh and Pakistan still below 2 per cent.
And, for once in the investment world, increasing regulation offers tailwinds for frontier markets compared with the headwinds being seen recently in emerging markets, particularly China.
FIM is being represented in Australia by David Vella of capital advisory and fund placement firm Allen Partners. He says the manager’s frontier equities strategy complements emerging markets exposures due to the increased efficiency being shown by larger emerging markets (making it more difficult to beat the index).
He says FIM, which manages a total of about US$2.5 billion and has more than 30 investment professionals in London, Saudi Arabia and UAE, has a strong ESG engagement policy which helps the active nature of its stock selection for frontier equities.
“We’ve been talking to a number of groups, not just super funds,” he says. “It makes sense to have a dedicated frontier markets manager.”
