Private International Commercial & Industrial Financing Consultants

Frontier markets would seem to offer active fund managers potentially a source of good returns, as well as opportunities for portfolio diversification. However, these potential benefits do not come without risks and challenges. These risks should be considered when determining which particular markets to pursue, and be recognized in investment processes in risk-and-return targets. Let us look at a number of these.

1. Regulatory, and Trading Execution Risk: Although increased interest in frontier markets has been enabled by market liberalisation and increased openness to non-local investors, market barriers should not be underestimated. Foreign ownership restrictions, currency limits, local custody rules, local funding and registration requirements are widespread and sometimes difficult to navigate. Some markets even require foreign market participants to execute trades via local brokers.

2. Transaction Costs: In many markets, high local transaction fees and commissions inflate trading costs.
3. Currency Risk: Investors, who seek to build a frontier market portfolio, need to be aware that they face a higher risk of investment exposure to potentially volatile currencies.

4. Governance Risk: Standards of corporate governance and financial reporting among listed companies in some frontier markets can be, at the very least, uneven.

5. Sector and Sovereign Risk: Part of the attraction of frontier markets is their low correlation with developed and emerging markets. However, investors should be aware that frontier markets are dominated by a few sectors, and hence a sizeable allocation can result in concentrated exposures to certain sectors. Frontier market equities are highly exposed to sovereign risk.

6. Liquidity Risk: Illiquidity is a feature of many frontier markets. Investors may be unable to execute trades when they want, or at the size they want. Bid-offer spreads can also be relatively wide.

7. Operational Risk: In some frontier equity markets, investing entails increased operational risk. Failed trades may occur more frequently than in developed markets, as settlement processes may be less standardised, less automated, and more prone to errors.

8. Political risk: As the recent political unrest in the Middle East illustrates, many frontier markets have fragile systems of government, which can be prone to instability. Turmoil can in turn lead to rapid declines in the market value of securities traded in impacted countries.

Now, whether an asset manager is considering launching a passive product, seeking alpha generation, or running a thematic growth strategy, it is obvious that risk must be managed carefully.

A single country, or regional, approach to frontier markets investment can create very significant sovereign, and sector/ stock concentration, risks. These limit the investment scope in such a way that it results in few potential securities, which meet minimum, objective capitalization standards or other criteria. The strategy can also limit the amount of capital that a fund can put to work. This is because of the risk that an investment in a given security will be too large to trade effectively.

Certainly, one attraction of frontier-market returns is their lack of correlation to each other, and to developed and other emerging markets. This means that adding frontier-market investments to a broader investment strategy can, in fact, reduce overall risk, and very probably improve risk adjusted returns.

Unquestionably, issues related to illiquidity, trade execution and settlement should be factored into the decision making process, and whether a manager can create an investment product with an attractive risk-reward profile. A local presence can have significant potential benefits in this regard. Being on the ground can also help an organisation monitor and mitigate other key risks, such as a lack of disclosure in financial reporting, or the potential for political uncertainty to destabilize markets, etc.

Frontier markets undoubtedly offer what are very likely compelling investment opportunities, which satisfy investor demand. Frontier markets are growing rapidly, but are still new enough to offer significant return potential, and attractive correlation characteristics, as globalisation continues to unfold.

Nonetheless, asset managers must work diligently to assess whether a frontier product is a good fit for their portfolios. Performance potential and asset gathering are only part of the equation. To be successful in developing an effective frontier investment capability, managers must ensure that their approach to risk management takes into account the particular blend of risks, which these markets entail.