Table of Contents Overview of Frontier Markets... 1 The Frontier Markets Universe... 2 The Benefits of Investing in Frontier Markets... 5 Factors to Consider when Investing in Frontier Markets... 6 Should You Invest in Frontier Markets?... 10 Questions? Contact Us. For more information about frontier markets, contact your Segal Rogerscasey consultant, the nearest Segal Rogerscasey office (http://www.segalrc.com/about-us/contact-us-locations/) or Hilary Wiek at 203.621.3671 or hwiek@segalrc.com. To receive issues of Investment Focus and other Segal Rogerscasey publications as soon as they are available online, register your e-mail address via http://www.segalrc.com/register/. Segal Rogerscasey is a member of The Segal Group (www.segalgroup.net), which is celebrating its 75 th anniversary this year, and the Global Investment Research Alliance (http://www.giralliance.com/). 2
Introduction to the Frontier Markets and the Opportunity They Present for Investors Would you like to invest in Fidson Healthcare, a publicly traded company that just completed a state-of-the-art factory and is approved by the World Health Organization for distribution of drugs desperately needed in Africa, such as for Malaria and HIV? And whose stock was up more than 135 percent in 2013? To take advantage of this opportunity, a portion of your assets would have to be allocated to frontier markets because Fidson is traded in Nigeria, the third largest of the frontier markets. Similarly, if you want to invest in an investment-grade country whose public debt was only at 15.6 percent of Gross Domestic Product (GDP) in 2013, whose unemployment rate was at 5.3 percent, and where GDP grew 5 percent, that country is Kazakhstan, which is rich in minerals, metals and fossil fuel and is also among the frontier markets. From Argentina to Zambia, frontier markets offer an opportunity to invest in growth characteristics and economic environments very different from those of developed countries. This Investment Focus discusses some of the characteristics of frontier markets as well as how and why, if at all, an investor should consider an allocation to the asset class. Overview of Frontier Markets Like the countries conventionally known as the emerging markets, which came into focus around the late 1980s, a new subset of rapidly developing countries is now garnering increased attention from the institutional investment community. Frontier markets encompass regions that are generally less economically developed than emerging markets. Frontier market equities have attracted investors seeking high returns and an uncorrelated asset class; however, as with emerging market equities, investors should be mindful of economic, social and political risks. Frontier economies capital markets are not fully developed, meaning they are small and relatively illiquid. To put Frontier market equities have attracted investors seeking high returns and an uncorrelated asset class; however, as with emerging market equities, investors should be mindful of economic, social and political risks. this in perspective, frontier markets collectively represent less than 1 percent of global stock market capitalization, and even though many countries are represented in various frontier markets indices, most have aggregate market values that are extremely small compared to markets in more developed economies. When the International Finance Corporation (IFC) initially categorized frontier markets in the early 1990s, the countries included were generally low- to middle-income countries within the developing-markets universe that had more nascent capital markets compared to the emerging economies first identified in the 1980s. While this original classification by the IFC was primarily based on market capitalization, differentiation is now based largely on factors influencing liquidity, such as efficiency of infrastructure, market size, openness to foreign ownership, ease of capital inflows and outflows, and political stability. Aside from traditional measures of growth and value, changes in these factors can offer an additional, and often significant, dimension for investment returns. 1
Index provider Morgan Stanley Capital International (MSCI) breaks the frontier markets universe into five distinct regions: the Americas, Europe and Commonwealth of Independent States (CIS; essentially the area of the former Soviet Union), Africa, the Middle East, and Asia. Although the classification is based on geographic location, and the countries within these regions are heterogeneous entities, some do share common growth drivers within their regions. For instance, in the Middle East, high-income Persian Gulf states such as Kuwait and Oman have deep oil reserves and share global reliance on oil for their economic well-being. Countries like Bahrain, within the same region, have successfully diversified their economies to include international services and tourism, although oil may still play an important role in their economies. Fast-growing economies in the Sub-Saharan African and Asian regions also share some similar growth drivers. Many, such as Kenya, Mauritius and Sri Lanka, rely on revenues from tourism, while others, like Kazakhstan and Nigeria, have the ability to take advantage of rich natural resources. Overall, African frontier stock markets have been concentrated in the Financial Services and Consumer Staples sectors, and Asian stocks tend to be concentrated in Financial Services and Energy. In the Americas, Argentina dominates frontier markets in terms of market capitalization, partly because the other wealthier Latin American countries have been categorized as emerging markets. Argentina was once considered an emerging market, but economic policy failures in the early 2000s caused its demotion. Latin American and Caribbean countries are known for having abundant natural resources, poor infrastructure and commodities-driven economies. Long histories of socioeconomic inequality and political upheaval have plagued these countries as well. The 2009-to-2011 run-up in some commodity prices presented attractive opportunities for international investors in this region. The Europe and CIS region comprises a diverse mix of markets at varying stages of economic development, as they have all rebuilt from the Communist era in different ways. Recent performance has been poor, reflecting the instability in the European region as a whole. From an economic-diversity perspective, however, this region provides a wide variety of investment options, although the Energy sector has seen more activity relative to the others. The Frontier Markets Universe Common index providers have established proprietary frontier markets indices, both for the entire market opportunity set as well as for regional and country-specific subsets. Each provider has developed different methods for classifying a frontier market country, causing material performance variances between indices. Eligible country membership is shown in Table 1 on the next page for three popular frontier markets indices: Financial Times and Stock Exchange (FTSE) Frontier 50 Index, MSCI Frontier Markets Each [index] provider has developed different methods for classifying a frontier market country, causing material performance variances between indices. Index, and Standard & Poor s (S&P) Frontier Broad Market Index (BMI). Less than half of the 39 countries listed are represented in all three indices, 12 have exposure to two of the three indices, and almost one-fourth of the countries listed have representation in only one index. Each index has a bias toward the Gulf states, which comprise more than 50 percent of their allocations. There is a heavy concentration to the Financials sector in all three indices. 2
Table 1: Country Membership for Three Popular Frontier Markets Indices Country Africa FTSE Frontier 50 Index MSCI Frontier Markets Index S&P Frontier BMI Index* Botswana Cote d Ivoire Ghana Kenya Mauritius Morocco Namibia Nigeria Tunisia Zambia Americas Argentina Ecuador Jamaica Panama Trinidad & Tobago Asia Bangladesh Pakistan Sri Lanka Vietnam Europe/CIS Bulgaria Croatia Cyprus Estonia Kazakhstan Latvia Lithuania Macedonia Malta Romania Serbia Slovakia Slovenia Ukraine *As of May 2013 Continued on next page 3
Table 1 (continued): Country Membership for Three Popular Frontier Markets Indices Country Middle East FTSE Frontier 50 Index MSCI Frontier Markets Index S&P Frontier BMI Index* Bahrain Jordan Kuwait Lebanon Oman Qatar UAE *As of May 2013 Sources: FTSE, MSCI and S&P-Dow Jones indices, as of December 2013 Of the three indices, the S&P Frontier BMI Index provides the broadest opportunity set, with more than 500 constituents, or holdings, across 36 countries. The MSCI Frontier Markets Index has roughly 140 constituents across 26 countries. The FTSE Frontier 50 Index is the most concentrated, including only 50 of the most liquid constituents across 26 countries. The S&P Frontier BMI Index provides the broadest opportunity set, with more than 500 constituents, or holdings, across 36 countries. Similar to passive indices in the space, most actively managed frontier markets strategies have high sector concentration within their portfolios. With the exception of two strategies in the evestment Frontier Markets Equity Universe, the Financials sector represents the greatest portion across portfolios. Of the 12 active strategies with available holdings-based data (see Table 2), as of September 30, 2013, the Financials sector comprised between 17-59 percent of portfolios, with an average and median of 35 percent. Consumer Staples, Consumer Discretionary, Industrials, Materials, Telecom and Energy typically follow in descending order. Healthcare, Technology and Utilities have historically held small allocations within these portfolios. Most portfolios will hold 40-100 stocks at any given point in time, and will have about one-third of their portfolio invested in their top 10 holdings. Table 2: Frontier Markets Portfolio Characteristics I Concentration of Holdings Number of Portfolio Holdings Percent Holdings in 10 Largest Stocks Number of Countries in Portfolios Average 70 40 23 Median 44 42 19 Range 27-318 5-71 10-37 Source: evestment Alliance 4
The Benefits of Investing in Frontier Markets In 2011, Citigroup economists Willem Buiter and Ebrahim Rahbari investigated the likely future sources of global economic growth between 2010 and 2050 in their work Global growth generators: Moving beyond emerging markets and BRICs. 1 Their conclusion pointed to 11 countries leading the charge for growth over the next 40 years: Bangladesh, China, Egypt, India, Indonesia, Iraq, Mongolia, Nigeria, Philippines, Sri Lanka and Vietnam. Six of these countries Investors interested in frontier markets seek to capitalize on greater economic growth opportunities associated with the early stages of economic development that are typically not available in emerging and developed markets. are considered frontier economies, while the remaining five are classified as emerging. Investors interested in frontier markets seek to capitalize on greater economic growth opportunities associated with the early stages of economic development that are typically not available in emerging and developed markets. In addition to the long-term growth story, there are other interesting factors leading investors to consider allocating capital to the frontier markets. Table 3 shows five-year monthly correlations between developed, emerging market and frontier market MSCI indices as of June 30, 2013. Table 3: Global Equity Correlation Comparison (Five-Year Monthly Correlation) MSCI USA MSCI World MSCI World ex USA MSCI Emerging MSCI Frontier MSCI Frontier ex GCC* MSCI Frontier Africa MSCI China MSCI USA 1.00 MSCI World 0.98 1.00 MSCI World ex USA 0.93 0.98 1.00 MSCI Emerging 0.86 0.92 0.93 1.00 MSCI Frontier 0.78 0.81 0.80 0.77 1.00 MSCI Frontier ex Gulf Cooperation Council (GCC)* 0.72 0.77 0.78 0.78 0.92 1.00 MSCI Frontier Africa 0.52 0.55 0.56 0.55 0.78 0.89 1.00 MSCI China 0.71 0.78 0.81 0.91 0.65 0.70 0.52 1.00 * The MSCI Frontier ex GCC Index does not contain GCC (Gulf Cooperation Council) countries. Sources: Old Mutual Global Index Trackers U.S. LLC and MSCI It is clear that the three frontier markets indices have relatively low correlations to their more developed counterparts, so a case could be made for diversifying away from other equity market categories. With the exception of the relationship of the MSCI Frontier Markets Index to the MSCI World Index, each of the three frontier indices has a 0.8 or lower correlation to the MSCI USA Index, World ex USA Index and MSCI EM Index. The regional versions exhibit the lowest correlations to the developed indices; MSCI Frontier Africa exhibits the lowest correlations to the developed world options, followed by Frontier ex GCC and the MSCI Frontier Markets Index. 1 BRICs is the acronym for an association of five major emerging national economies: Brazil, Russia, India, China and South Africa. The referenced study, Centre for Economic Policy Research s Policy Insight No. 55, published April 2011, may be accessed by clicking this link: http://www.willembuiter.com/3glite.pdf. 5
Another advantage of frontier markets is that average valuations of the underlying stocks tend to be lower in terms of price-to-earnings than in more developed markets, as shown in Table 4. Along with higher growth projections compared to emerging and developed countries, inexpensive valuations could be a factor in attracting foreign investors. In addition, yields have historically been higher in this space compared to the yields in emerging and developed equities. Table 4: Frontier Markets Portfolio Characteristics II Comparing Yields and Valuations Benchmark Dividend Yield Price/Earnings Price/Book Value MSCI EM 2.74% 11.98x 1.53x MSCI Frontier 3.87% 12.55x 1.62x MSCI EAFE 3.08% 16.37x 1.63x MSCI World 2.55% 18.86x 2.03x Source: MSCI, as of September 30, 2013 Factors to Consider when Investing in Frontier Markets For all of these advantages, frontier economies can also be politically, culturally and economically unstable, sometimes resulting in volatile returns. The 2012 re-nationalization of YPF S.A. in Argentina, the oil and gas company previously owned by the Spanish firm Repsol S.A., led to shares falling sharply by more than 30 percent. The Vietnamese stock market dropped 75 percent from its peak in February 2007 through early March 2009, as investors decided that Vietnam s dependence on exports to recession-laden economies would severely curtail this burgeoning export market. A terrorist attack in September 2013 that killed more than 60 people at a shopping mall in Kenya will likely affect tourism and foreign investment into that region in the short term. Graph 1 provides the standard deviation of returns on a rolling three-year basis across select regional MSCI indices. Graph 1: Rolling Three-Year Standard Deviation for Global MSCI Indices, as of 12/31/13 45 40 35 30 25 20 15 10 5 0 Dec-2006 Mar-2007 Jun-2007 Sep-2007 Dec-2007 Mar-2008 Jun-2008 Sep-2008 Dec-2008 Mar-2009 Jun-2009 Sep-2009 Dec-2009 Mar-2010 Jun-2010 Sep-2010 Dec-2010 Mar-2011 Jun-2011 Sep-2011 Dec-2011 Mar-2012 Jun-2012 Sep-2012 Dec-2012 Mar-2013 Jun-2013 Sep-2013 Dec-2013 MSCI EAFE MSCI EM MSCI Europe MSCI Frontier Markets MSCI USA MSCI World ex USA MSCI World Source: evestment Alliance 6
Frontier markets stocks tend to be thinly traded, have foreign ownership constraints and exhibit higher per-share transaction costs than in more developed equity markets. These operational hurdles can make managing a large portfolio in frontier markets difficult. Vanguard released a report at the beginning of 2013 that illustrates the liquidity differences between emerging and frontier markets, as seen through a hypothetical comparison of how long it would take to fully liquidate the MSCI Emerging Markets and MSCI Frontier Markets indices. Their hypothetical example (which excludes the cost of the sale as well as any negative price impact due to low volume) shows that all emerging markets securities can be liquidated in less than 0.2 days. However, only 7 percent of a frontier markets portfolio could be liquidated in the same period. To liquidate 32 percent of a frontier markets portfolio would require up to a full day, and to liquidate 94 percent of the portfolio would require 10 trading days. 2 Despite low valuations and attractive GDP figures, recent performance in the frontier markets has been poor. One of the realities of financial markets is that stock returns do not always correlate well with economic growth rates. Despite low valuations and attractive GDP figures, recent performance in the frontier markets has been poor. The disconnect occurs because investor sentiment quite often overrides any results coming at the company or even country level. Such disconnects between value and valuation can offer a compelling investment opportunity, yet can persist for extended periods. Graph 2 provides trailing performance metrics across select regional MSCI indices, followed by calendaryear returns in Graph 3 on the next page. Graph 2: Regional Universe Performance Ranking of Global MSCI Indices Returns as of 9/30/13 40% 30% 20% 10% 0% -10% MSCI EAFE MSCI EM MSCI Europe MSCI Frontier Markets MSCI USA MSCI World ex USA MSCI World Median Quarterly, YTD, and Trailing Performance, as of 9/30/13 Active vs. Passive Performance Comparison Percentile by Trailing Returns MRQ YTD 1 Year 3 Years 5 Years 7 Years 10 Years 5 th Percentile 14.1% 26.3% 33.0% 17.3% 15.1% 9.6% 13.5% 25 th Percentile 10.1% 20.0% 24.4% 13.6% 10.9% 6.8% 11.1% Median 8.3% 16.7% 20.0% 11.9% 9.1% 5.2% 9.7% 75 th Percentile 6.6% 12.1% 15.2% 9.8% 7.5% 4.0% 8.4% 95 th Percentile 2.4% 1.2% 3.1% 2.5% 2.4% 1.2% 6.4% # of Observations 975% 973% 972% 879% 751% 564% 360% Source: evestment Alliance 2 Philips, Christopher B., Redding, Brad, 2013. Exploring the next frontier: A review of frontier equity markets : The Vanguard Group. http://www.vanguard.com/pdf/s357.pdf 7
Graph 3: Regional Universe Performance Ranking of Global MSCI Indices Calendar-Year Returns 100% 80% 60% 40% 20% 0% -20% 40% -60% -80% MSCI EAFE MSCI EM MSCI Europe MSCI Frontier Markets MSCI USA MSCI World ex USA MSCI World Median Calendar-Year Returns Percentile by Trailing Returns 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 5 th Percentile 34.2% 33.5% 44.0% 39.7% -26.7% 70.5% 30.7% 5.0% 28.7% 39.3% 25 th Percentile 22.3% 17.6% 27.7% 18.7% -37.4% 45.4% 19.5% -2.7% 20.3% 30.3% Median 17.7% 13.2% 22.8% 11.9% -41.7% 36.2% 14.6% -6.7% 17.0% 25.9% 75 th Percentile 14.0% 9.7% 18.9% 7.0% -45.7% 29.5% 11.5% -11.3% 14.1% 19.7% 95 th Percentile 7.8% 4.8% 11.6% -7.7% -54.5% 20.2% 6.1% -19.8% 3.6% 2.5% # of Observations 533% 608% 712% 824% 931% 1029% 1047% 1062% 1072% 989% Source: evestment Alliance The MSCI Frontier Markets Index only outpaced the MSCI USA Index in the trailing 10-year period. It lagged each index listed in the trailing five- and seven-year periods, and only outpaced the MSCI EM Index in the trailing three-year period. Recent performance has improved, as the Index outpaced four of the listed indices in the trailing one-year period, and only trails the MSCI USA Index year-todate. Frontier markets performed quite well from 2003 to 2007, but fell out of favor during the 2008 Global Financial Crisis and its aftermath because investors shied away from riskier and less liquid investments. Even though the institutional investment universe for frontier markets strategies is starting to grow, as investment managers continue to build their track records and begin marketing their portfolios, it is still quite young and very limited. Morningstar does not separate frontier markets strategies from its Diversified Emerging Markets Equity universe. On the other hand, evestment Alliance has segregated frontier markets strategies into its own universe, evestment s Frontier Markets Equity 8
universe, which began 2013 with 16 listed strategies and had added five more as of September 2013. All 21 strategies are listed as Active, meaning they are available for investment; however, none of them has a 10-year track record, two have a seven-year track record, five have a five-year track record, and the rest began less than five years ago. Assets under management in the universe are still fairly small; only 10 of the listed strategies have more than $100 million under management. Two of the products offered take a purely passive approach, while the rest actively manage their portfolios. Out of the 19 actively managed strategies available, two utilize a quantitative process, 12 take a fundamental approach, and five combine the two approaches. In terms of vehicle, 12 strategies are available via separate account, six via commingled fund and the rest can be accessed by mutual fund. In the short period they have been operating, actively managed strategies in frontier markets have been able to outperform a passive approach, particularly over the longest timeframes. The MSCI Frontier Markets Index falls in the fourth quartile of the universe in the trailing three-, five- and sevenyear periods, as shown in Graph 4. The Index performs in the third and second quartiles in the trailing one-year and year-to-date periods, respectively. Graph 4: Regional Universe Performance Ranking of MSCI Frontier Markets-ND Index Returns as of 9/30/13 40% 30% 20% 10% 0% -10% Median Benchmark Active vs. Passive Performance Comparison Percentile by Trailing Returns MRQ YTD 1 Year 3 Years 5 Years 7 Years 5 th Percentile 11.1% 29.8% 38.1% 12.1% 12.1% 8.1% 25 th Percentile 7.5% 23.3% 30.2% 10.3% 7.5% 7.2% Median 6.2% 17.2% 24.1% 8.9% 6.2% 6.1% 75 th Percentile 5.4% 11.2% 18.2% 5.4% 4.3% 5.1% 95 th Percentile 4.0% -0.1% 7.6% 3.5% 0.2% 4.2% # of Observations 22% 22% 22% 16% 8% 2% Source: evestment Alliance 9
Should You Invest in Frontier Markets? Investors interested in gaining access to the frontier markets should be aware of the fundamental risks. Gaining access through a passive approach is the least expensive method, but investors should be aware of the inherent concentration to the Gulf states and Financials sector in the indices. A passive approach removes an active manager s ability to allocate away from fundamental risks present in frontier economies. Regional frontier markets indices are available for investors, but they are often strongly influenced by the fundamental risks of single member countries. Even though actively managed strategies have been able to outpace passive approaches, finding managers who have been able to consistently add value in the space is challenging, as most actively managed strategies have relatively short track records. The different methodologies for creating benchmarks also presents an uneven measuring stick for comparing actively managed strategies. Graph 5: $10 Million Commingled Fund Fees in Basis Points (bps), as of 9/30/13 160 140 120 100 80 60 40 20 0 Frontier Markets Equity Emerging Markets Equity U.S. Small Cap Equity International Equity U.S. Large Cap Equity Source: evestment Alliance Investing in the frontier markets also carries a hefty price tag. Idiosyncratic trading regulations and limited information flow tend to cause fees to be higher in the frontier markets universe than what is offered for more developed equity markets. Graph 5 compares Investing in the frontier markets also carries a hefty price tag. Idiosyncratic trading regulations and limited information flow tend to cause fees to be higher in the frontier markets universe than what is offered for more developed equity markets. the median fee on a $10 million mandate through a commingled vehicle, as reported in the evestment Alliance database. Investors can use pooled fund investments to gain economy of scale in transaction costs as well as ease of implementation. Those considering accessing these markets through a separate account should work with their custodial banks to obtain the additional cost estimates that investing in frontier markets strategies may carry as well as an understanding of the paperwork and maintenance required to open brokerage accounts in these countries to allow for trading and holding securities. Higher costs also result from lower liquidity, as compared to more developed markets. The high fees, illiquidity and inherent fundamental risks involved with investing in frontier markets may cause some investors to avoid direct investment in the space. Although the upside for frontier markets investing may look attractive, the challenges and risks can be significant. For many investors, the 10
downside of frontier markets investing may outweigh the upside potential. As an alternative, exposure to frontier economies can be gained through emerging markets mandates: As of September 2013, evestment lists that 50 emerging markets mandates have a 5 percent or greater allocation to frontier economies, 20 strategies have 15 percent or more, and 7 strategies have a 25 percent or greater allocation to frontier markets. For large, sophisticated investors whose stable of managers already includes emerging markets, who have a long time horizon to complement a buy-and-hold approach, and who are interested in gaining exposure to frontier markets, we suggest considering hiring a dedicated investment manager that offers product in the space. Those investors should be prepared for Our recommendation to the majority of investors is to allow emerging markets managers to invest opportunistically in frontier markets, assuming they have the ability and inclination to do so. a potentially volatile ride, and should take note of the inherent large sector and country concentration that frontier markets portfolios typically offer. Discrete frontier markets mandates are not appropriate for the majority of investors. Portfolios may be too small to slice that finely, the risks may outweigh the benefits, and the costs may be higher than is reasonable for such a small allocation, even for very large plans. Our recommendation to the majority of investors is to allow emerging markets managers to invest opportunistically in frontier markets, assuming they have the ability and inclination to do so. In this way, the benefits of some exposure to frontier markets can be garnered while the risks can be mitigated in a more liquid and more diversified portfolio than a purely frontier strategy could offer. Questions? Contact Us. For more information about frontier markets, contact your Segal Rogerscasey consultant, the nearest Segal Rogerscasey office (http://www.segalrc.com/about-us/contact-us-locations/) or Hilary Wiek at 203.621.3671 or hwiek@segalrc.com. To receive issues of Investment Focus and other Segal Rogerscasey publications as soon as they are available online, register your e-mail address via http://www.segalrc.com/register/. Segal Rogerscasey is a member of The Segal Group (www.segalgroup.net), which is celebrating its 75 th anniversary this year, and the Global Investment Research Alliance (http://www.giralliance.com/). Segal Rogerscasey provides consulting advice on asset allocation, investment strategy, manager searches, performance measurement and related issues. The information and opinions herein provided by third parties have been obtained from sources believed to be reliable, but accuracy and completeness cannot be guaranteed. Investment Focus and the data and analysis herein is intended for general education only and not as investment advice. It is not intended for use as a basis for investment decisions, nor should it be construed as advice designed to meet the needs of any particular investor. Please contact Segal Rogerscasey or another qualified investment professional for advice regarding the evaluation of any specific information, opinion, advice or other content. Of course, on all matters involving legal interpretations and regulatory issues, plan sponsors should consult legal counsel. Copyright 2014 by The Segal Group, Inc. All rights reserved.