While growth in developed economies currently ranges between slow and stalled, emerging economies have seen tremendous growth powered largely by the BRIC nations consisting of Brazil, Russia, India and China.
This economic growth hasn’t, however, consistently translated into returns for investors, who are now looking to find countries that will be the next BRICs—places that will deliver the kind of powerful growth enjoyed over the last decade by the larger emerging markets.
As a result, the so-called frontier markets—Vietnam, Ukraine, Nigeria and some central Asian and Latin American markets—have been attracting considerable capital inflows.
Experts warn that while frontier markets have high growth potential, they also pose risks in terms of political instability, infrastructure, currency and rule of law.
A panel of experts at the recent Bloomberg Markets’ web conference discussed strategies that can help investors navigate the complex range of options in emerging and frontier markets.
To begin with, considering emerging markets as a uniform and monolithic asset class is misleading, said Michael Dunn, chief research officer at Boston-based TruColor Capital Management.
“Even within the BRICs there are much wider varieties of opportunities available than in four largest [industrial] economies—U.S., Japan, UK and Germany,” he said.
Investment filters against risk factors such as exposure to Europe, high economic dependence on any one commodity, runway inflation and poor demographics, will rule out Russia, China and India, leaving only Brazil among the group, added Dunn.
In this specific case, alternatives to the screened-out BRIC economies could be found among frontier markets: in Asia they include the Philippines, Sri Lanka and Indonesia; in Latin America, Chile, Columbia and Mexico.
“All of these have pretty good GDP growth, low inflation, strong population growth, low external debt,” Dunn said, while warning that “none of these are buy-and-forget investments.”
There are significant differences to consider between emerging and frontier countries, said Komal Sri-Kumar, chief global strategies at TCW Group in Los Angeles. “The market capitalization is significantly larger in the case of BRIC countries than frontier markets; [also] as an investor, be prepared for substantially greater volatility in frontier markets,” he said. “Don’t call your manager every quarter to see why they lost money in that period; wait patiently for 5 to 6 years to get good returns.”
Additionally, the risk of exchange rate fluctuations is likely to be “very marked” in frontier markets. “You might have done very well for a couple of years, but because of a political change, if the currency in that country crashes and exchange controls are imposed, you may not be able to realise the good returns that you enjoyed on paper during the past few years,” said Sri-Kumar.
Diversification, he said, is of very little help in frontier markets and given that they have small capitalization and much smaller companies, a balanced portfolio is difficult to structure despite investing in different countries.
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Both emerging and frontier markets tend to be volatile and are affected in varying degrees by such global macro events as the current European crisis.
“Although emerging markets have disconnected themselves given the high levels of growth they’re witnessing than the developed markets, I don’t think that is really the case when there’s such big macro issues at play,” said Gautam Khanna, managing director, portfolio management at New York-based Cutwater Asset Management.
“With five-year Italy bonds trading almost at 8%, it really makes you wonder if you are [more] comfortable buying Indonesia at 180 [bps] over, when a G-7 economy like Italy is trading at 7% to 8%,” said Khanna.
“In some of the frontier markets you are looking at fixed income returns of 12% to 15%, if not higher, whether or not there’s a credit crunch in the European financial markets,” said Sri-Kumar.
A credit crunch in the developed world doesn’t make things worse for frontier countries. “And that’s the reason they should be a permanent part of your overall portfolio,” he added.
Khanna places Indonesia and the Philippines high on list of potential destinations for fixed-income investing. “They are strong candidates for upgrade from the rating perspective; Vietnam is also longer-term potential upgrade candidate, and Columbia as well,” he said.
There are opportunities in countries undergoing a political or governmental turnaround. Dunn puts Argentina, Sri Lanka and Bangladesh in that group.
“We consider political risk very important lower down the development spectrum in emerging markets,” said Sri-Kumar. “Political assessment is not different whether it is a BRIC country or a frontier economy, but it’s more important in the case of the latter.”
Many money managers who count political stability among the more desirable characteristics tend to favour democratic societies. Khanna says there are various flavours of political systems in emerging markets which makes it important to consider “rule of law which goes hand in hand with political stability.”