We publish monthly letters commenting on developments in our frontier markets and our funds. Read the latest as well as previous editions here.
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Frontier markets are the new emerging markets and include countries such as Vietnam, Bangladesh, Pakistan, Sri Lanka, Nigeria and Kenya. These are countries coming from a low level of economic development but which have gone through a transformation in the past decade and now belong to the fastest growing economies globally. From time to time economies from the Middle East are also included in the frontier market group. Tundra has chosen not to focus on a majority of the Middle East nations given that countries such as Qatar, U.A.E. and Kuwait have a similar or higher level of economic development than Western Europe and it is therefore reasonable to assume that the region will not be subject to the same level of economic growth as the remainder of frontier markets over the next few decades.
Economic growth in frontier markets is driven by:
- Demographics: Frontier markets have young fast growing populations. This creates economic growth as more and more people join the work force. According to statistics from the U.N., the population in frontier markets will grow by 1.2% in the next two decades compared to 0.6% in emerging economies and 0.2% in the developed part of the world. Today, frontier markets represent close to 30% of the global population but only 1% of the global market cap. People in countries such as Pakistan, Kenya and Sri Lanka are also becoming better educated. Education contributes to higher levels of productivity.
- Urbanisation: Frontier markets are going through a clear urbanisation trend – gradually more and more people are moving from rural to urban areas. As this transition takes place, infrastructure investments increase, children and young people get access to modern education and a growing portion of consumption takes place through the formal economy in super markets and department stores rather than through the local market. In countries such as Sri Lanka, Kenya and Bangladesh, less than 40% of the population is urbanised compared to 80% in Western Europe and the US.
- Infrastructure investments: Infrastructure investments take place continuously in frontier markets. Reliable power supply is ensured, the road networks are expanded, and a growing proportion of the population gets access to computers and telecommunication networks.
- Foreign direct investments: Foreign direct investments in frontier markets have increased over the past decades. For several years now, Nike produces more shoes in Vietnam than in China and Samsung Electronics, the South Korean electronics giant, produces half of its handsets in Vietnam. We recognise this pattern from history – Japan, South Korea, Taiwan and China have already gone through this phase. Now it is time for countries such as Vietnam, Bangladesh and Pakistan to take their turn.
- Rising political stability: We tend to associate countries in Africa, Asia and other developing parts of the world with political instability. This is only partially true. Never before has Africa, for instance, had so many democratic governments as today. In addition, the number of armed conflicts has seen a decline in the past decade.
Frontier equity markets tend to still be dominated by domestic investors. The number of foreign pension funds, insurance companies and asset managers which are active in frontier markets is limited. To a large extent, these markets are still uncharted territory. The limited number of foreign investors also means that frontier equity markets tend to be less analysed. As an investor with a sizeable dedicated investment team, this is something we can take advantage of. For long-term investors it creates opportunities to find under-researched and undervalued companies.
Limited foreign investor participation also contributes to frontier markets having relatively low correlation with other equity markets and asset classes. Replacing a portion of a global equity portfolio with frontier markets can contribute to reducing the overall risk level of the portfolio.
Just as frontier markets offer great return potential over time, the asset class is also associated with risks.
- Market liquidity is still worse than in more developed asset classes.
- Despite improvements in terms of political stability, frontier markets are still associated with more political risk than emerging markets.
- Frontier market currencies tend to be more volatile than emerging and developed market currencies.
- Poor corporate governance and presence of corruption can be assumed to be more prevalent than in other parts of the world.
Tundra works proactively with these issues with the help of a dedicated sustainability team.
Frontier markets have historically struggled with high gearing. This is no longer the case. Write downs combined with high economic growth have resulted in frontier markets today having a lower gearing (measured as external debt as a portion of GDP) than for instance the G7 countries.
Suitable for actively managed funds
Passive investment vehicles such as ETFs and index funds have grown in popularity during the past years. Frontier markets are less suitable as targets for passive vehicles. Transaction costs are typically higher; they tend to lack a functioning futures market; indices rarely fully reflect the structurally most attractive investment opportunities, and finally, because frontier market companies tend to have less analyst coverage, substantial opportunities for outperformance are created through active management. This is also frequently reflected in the poor relative return of passive vehicles targeting frontier markets.