When asked about investing in frontier markets, pension funds say they like the idea but they need to move with caution.

Ramon Tol, an equity fund manager at Blue Sky Group, which manages €16bn on behalf of Dutch pension funds, explains that the lingering unrest in the Middle East means that despite a lot of talk, current investment allocation is low.

The group has €120m, or 2 per cent of its total equity portfolio, invested in exotic markets through a global frontier market fund manager. “We are 1 per cent below our target allocation for frontier markets. The most important reason is the current turmoil in the market and the risk of the Arab spring being contagious to the rest of the region,” says Mr Tol.

“The Middle East represents a very large part of frontier markets, and has a significant impact on our allocation.” Indeed, a lot of investment is being kept on the sidelines in terms of equity. But the question is whether pension funds are making a mistake by not picking up rare sources of income in a world that has largely run out of yield and growth.

Fund managers believe so. After a difficult few years for frontier markets, the future looks brighter. “We strongly believe investors in frontier markets will make money over the next five years, unlike the last five,” says Bernard Moody, investment director at Advance Emerging Capital.

Mark Mobius, executive chairman at Templeton Emerging Markets and one of the torch bearers for this type of investing, is equally optimistic. “The rapid advance of many frontier market countries toward emerging market status gives their investors economic opportunity for three main reasons: growth potential, valuations and correlation,” he says.

Some of the rising stars are Nigeria, Ghana, Qatar and Vietnam. “In essence, they represent what emerging market countries like Brazil, Russia, India and China were 20 years ago,” says Mr Mobius.

Sub-Saharan countries in particular are benefiting from rapid growth and a growing middle class. In Nigeria, gross domestic product per capita has increased from $390 in 2000 to $1,650 in 2012, according to Fidelity Worldwide Investment.

Andrew Brudenell, manager of the HSBC GIF Frontier Markets fund, says: “Nigeria has a very large and growing population that is entrepreneurial and a political system that has seen much more stability in the last few elections, empowering it to make the necessary investments to reform and diversify the economy.”

Promising growth stories can be found elsewhere, such as in Asia and the Middle East, where economies are boosted by local resources, better infrastructures and the development of capital markets.

Another positive aspect is that most of this growth is often not tied to the rest of the global economy, so can act as a defensive play against the jitters of western markets.

It is not all rosy, however. There are still reasons to be doubtful about the merits of investing in countries that are characterised by shallow market depth and poor liquidity. Pension funds, with all their fiduciary responsibilities on behalf of employees, should be understandably cautious when it comes to investing in economically and politically fragile countries.

As Mark Livingston, investment director in the emerging markets team, puts it: “The real risk in these markets is the permanent loss of capital rather than the day-to-day fluctuations of the stocks within their universe.”

Sam Vecht, director of emerging markets and manager of the firm’s Frontiers Investment Trust, adds: “Clearly, there are significant risks in investing in frontier markets. It would be unsurprising if out of 140 less developed countries, there were not some that had less developed business practices.”

Looking at recent performance, frontier markets have not done very well. In the heat of the 2008 crisis, their performance was worse than that of developed countries, with the MSCI Frontier Markets index plummeting more than 54 per cent, compared with 41 per cent for the MSCI World index.

In the past year, frontier countries have lagged behind developed markets by about 10 per cent, posting a meagre 0.03 per cent return. But looking over a longer time period, the picture becomes more favourable. Over 10 years, the MSCI Frontier Markets index outperforms the MSCI World on an annualised basis.

Sven Richter, head of frontier markets at Renaissance Asset Managers, says: “While frontier markets are more volatile than developed markets, investors have been rewarded with higher returns for taking on higher volatility over the last 20 years. This is a trade-off pension funds in developed countries will have to make.”

And it does look like some pension funds are ready to listen. Nick Greenwood, pensions manager at the Royal County of Berkshire Pension Fund, invests in frontier markets via an equity fund, in an African private equity fund of funds and an infrastructure fund. “Frontier markets offer investors good investment opportunities, much as emerging markets did in the 1980s and 1990s,” he says.

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