The latest hot investing sector to bottom out: Emerging markets.
Once a favourite of investors amenable to living on the knife edge of risk and reward, emerging markets have been dragged down by their slowing economic growth. Many strategists suggest investors forget about emerging markets for now and instead put money in developed economies like the United States and Europe.
Another thought is to consider frontier markets, a subset of emerging markets with economies that are still in the rapid growth phase. Examples: Argentina, Bangladesh, Kazakhstan, Pakistan, Vietnam and the African nations of Kenya and Nigeria.
"People are very excited about Africa," said Gavin Graham, chief strategy officer at Integris Pension Management and co-author with Al Emid of Frontier Markets for Dummies. "It's the new China. You've got demonstrable improvement in political and corporate governance, and you're starting to see some fairly major growth in GDP. The possibilities there are very attractive."
Mr. Graham describes frontier markets as being what major emerging markets such as Brazil, Russia, India and China – often grouped together as the BRIC nations – were 15 to 20 years ago. That is, fast-growing economies attracting a lot of foreign interest.
These countries still have growing economies, but the momentum has faded. India's economy grew last year by 4.4 per cent, compared to 9 per cent before the global economic crisis. China's economy grew by 7.4 per cent in the first quarter of this year, down from a long-term average rate close to 10 per cent. It's numbers like these that have prompted global investors to take profits in emerging markets over the past year or two.
Oil-rich Nigeria is an example of both the risks and rewards of investing in frontier markets. After a revision of its economic data, the country recently moved ahead of South Africa as the African continent's largest economy. The financial rating analysts at Moody's say Nigeria's economy will rank among the world's 15 largest by 2050. These indicators of growing economic success have produced a 12-month gain of 21.2 per cent for the Nigerian Stock Exchange All Share Index.
But Nigeria has also been battling a ruthless insurgency that threatens its economic growth. This week, 75 people were killed after an explosion at a bus station. A day later, gunmen killed a pair of guards at a school and kidnapped some 100 female students.
Looking at the broad frontier market group of countries, Mr. Graham sees some demographic advantages that will help economic growth. Birth rates are coming down, the populations are skewed to a younger age than Western countries and work forces are expanding. "And, you've got lots of people moving from the country to the city, which is where you get the big, explosive growth that you saw in India, China and Southeast Asia."
The dynamic growth of frontier markets explains why the MSCI Frontier Markets Index surged 25 per cent for the 12 months to April 15 in U.S. dollars, while the MSCI Emerging Markets Index fell 0.3 per cent. For the past three years, the frontier index averaged gains of 4.7 per cent and the emerging markets index fell 5.4 per cent annually.
In terms of volatility, frontier markets will give you all you can handle. The MSCI Frontier Markets Index lost 54 per cent in 2008 and 18.4 per cent in 2011, but gained 72.7 per cent rise in 2005.
The investment industry, with its innumerable emerging market funds, has been cautious with frontier market products. The one big name in the sector, the $82.4-million Templeton Frontier Markets Class, was closed to new investors in June, 2013, to help the company manage the flow of money going into frontier market stocks. The fund's 19.4-per-cent return for the 12 months to March 31 was far better than the 2.8 per cent average for emerging market funds.
The lack of mutual fund options means investors must look at exchange-traded fund options. Here are three listed on the New York Stock Exchange:
The iShares MSCI Frontier 100 ETF (FM): Close to 60 per cent of the fund is in Kuwait, United Arab Emirates and Qatar; the fees are high at 0.79 per cent.
The Guggenheim Frontier Markets ETF (FRN): Fees at 0.7 per cent, and a weighting of roughly 70 per cent in Chile, Argentina and Colombia.
The Global X Next Emerging & Frontier ETF (EMFM): Emerging markets like Malaysia, South Africa and Mexico take precedence over frontier markets like Vietnam, Pakistan and Nigeria; fees at 0.58 per cent.
Mr. Graham suggests putting 5 to 10 per cent of your portfolio's international exposure into frontier markets, and he thinks that reallocating this money from emerging market funds makes sense. This portfolio tweak isn't just about reaching for higher returns. According to Mr. Graham, frontier markets are also an effective way to diversify your portfolio.
Years back, one of the arguments in favour of holding emerging markets was that the stocks from these countries weren't correlated with developed markets. Mr. Graham said frontier markets are now a better way than emerging markets to get some portfolio content that won't rise and fall in the same way as Canadian, U.S. and other developed markets. His explanation: Because they're less developed, frontier markets are more influenced by domestic events than global events.
Mr. Graham expects frontier markets to produce the same returns over the decade ahead as emerging markets did in the past decade, which is about 7.5 per cent a year on average. If you've been looking at investing in emerging markets based on this past performance, shift your focus to frontier markets.