Brave investors should head for the frontier

Frontier market investment trusts offer a way into a compelling sector, says David C Stevenson.

Imagine the global financial system is a pond, shallow at the edges, but very deep in the middle. The US is at the centre. It has deep, liquid markets, but can send shockwaves all the way to the very edge of the pond, which consists of frontier markets such as Nigeria, Colombia, Qatar and Mongolia.

These markets are relatively shallow and vulnerable a nasty-looking ripple at the centre can be amplified by the time it gets to the edge, causing mayhem.

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This sums up the relationship between frontier (the shallow edge of the pond), emerging (a concentric ring around the centre) and developed world equity markets (the centre).

So when working out whether to invest in frontier markets, we must consider not just trade relationships, but also money flows. In short, your view on frontier markets depends largely on your view of what will happen in the US.

If the US avoids political disaster, we'll be in a risk-on' environment. Investors will feel bullish while cheap money flows. And as long as the centre stays calm, we can expect a greater variety of events within our pond ecosystem, with lots of different ripples and currents having an impact.

In the jargon, we can expect a greater dispersion of returns' some regions will do better than others. Maybe China will continue to disappoint, while the UK outperforms. So by studying capital flows from both central banks and the private sector, we can figure out a great deal about the likely direction of markets.

This is where research from London firm Cross Border Capital comes in. Cross Border believes we're halfway through a risk-on environment, with strong credit creation in the US private sector, and strong capital flows. But some areas notably emerging markets are having a much tougher time, China in particular.

The really interesting twist is that frontier markets seem to be doing a lot better than emerging markets. Traditionally, investors have seen frontier markets as an outgrowth of the emerging markets story.

In effect, Nigeria, Qatar and the like are the 21st-century equivalents of 1980s China. And looking at historic returns, emerging and frontier markets tend to be closely intertwined. But that's changed.

In the first nine months of 2013, the MSCI Frontier index rose 13.5% in US dollar terms, while the Emerging Market index fell by 4.2%. Cross Border also found that frontier markets have enjoyed stronger liquidity. This seems to be due to private-sector liquidity (retained earnings, household savings, and new credit).

Emerging-market liquidity is overwhelmingly determined by China, which in turn is negatively affected by trends in US liquidity. But frontier markets are the opposite.

In short, emerging-market liquidity correlates "closely with the Chinese business cycle, whereas frontier markets appear to correlate more closely with the US business cycle".

This is hugely important. It tells us there's a good chance that frontier markets will continue to diverge in the next few years, assuming we don't see a global meltdown. That makes them potentially very appealing, especially as valuations are low, and dividends rising. But like any complex, sometimes illiquid market, investors must be careful.

To my mind, exchange-traded funds are not the best way to invest here. Frontier indices tend to be a little flaky, and very dependent on the countries you include. They also tend to be dominated by small cliques of very big companies. I would rather pay a manager to decide whether a given country is risky, or a bargain.

But liquidity is another challenge. Most investors in actively managed funds use unit trusts. But many of these markets are simply too illiquid and shallow to accommodate the daily liquidity of a unit trust.

The good news is that investment trusts (which don't have to sell underlying investments when investors trade in their shares, and so are a viable way to invest in illiquid assets) fill the gap.

The grand-daddy of the UK's frontier markets sector is Dr Slim Feriani's Advance Frontier Markets Fund (LSE: AFMF). It picks key markets and themes, then chooses the best managers in each country or region. It's cost-effective for a fund of funds, with a total expense ratio (TER) of 1.58%, and Slim's team is first rate. But he faces strong competition from Sam Vecht at the BlackRock Frontiers Trust (LSE: BRFI).

Sam selects individual stocks he has big stakes in regional banks and property companies, many in the Middle East. BlackRock's fund has slightly stolen Advance's thunder, with a one-year return of 47% compared to Advance's 28%. This is reflected in a 6.8% premium for BlackRock, and a 9.6% discount for Advance.

Yet the BlackRock TER is far higher at 2.6%. Both funds have a strong Middle East bias, although Advance seems to be placing a bigger bet on Africa, which I think is wise.

Alternatively, you can invest in specific regions. I'm a big fan of Francis Daniels' Africa Opportunity Fund (LSE: AOF), on a discount of about 4%, with a 12-month return of 56%. It invests in anything from pan-African shopping groups, such as Shoprite, through to West African mobile phone groups, such as Sonatel.

The TER is 3.83%, but these are hard-to-access markets, and I think Africa is the great bullish bet of this decade.

In the Middle East, I like Qatar, which appears capital rich', swimming in excess liquidity and boasting a fast-emerging stock market, which also pays a decent yield.

Qatar Investment Fund (LSE: QIF) does what it says on the tin stakes in big banks and developers help it generate a yield of 3%, and it's on a discount of 12%.