Frontier markets lure – and reward – hardy investors

Risks have been rewarded by diving into Bangladesh, Ukraine, and other small developing nations.

After violence erupted in Kenya following December's disputed presidential election, the African nation's stock market might have seemed like a risky place to put money.

But some clients of Wambia Capital in Boyds, Md., evidently saw the situation differently. "Some of the clients said, 'If you see stock bargains [in Kenya], we want to buy them,' " recalls investment adviser Joseph Wambia. These seasoned investors "have already seen ups and downs in markets such as India's and Pakistan's," he explains. And now, as they seek fresh, new investment horizons, they believe "Africa is the next frontier," says Mr. Wambia, who plans to launch a hedge fund for investing in that continent.

Evidently, Wambia's clients aren't the only ones trolling for new opportunities. After exploring such emerging markets as Russia, China, and Brazil, more investors are venturing into smaller terrain from Bangladesh to Botswana.

In such "frontier markets," rising prices of commodities (oil, for instance) and economic and political reforms are spawning greater economic growth and higher corporate profits, experts say. As a result, many of their stock markets are delivering big returns – and helping their investors further diversify their portfolios.

Consider last year's stellar returns from this sector: In 2007, the S&P/IFCF frontier markets composite of 24 countries' markets posted a 45.6 percent total return, beating S&P indexes that track emerging and world markets.

Among specific frontier markets, Bangladesh's led the pack last year, with an eye-popping 128.3 percent gain. In addition, Côte d'Ivoire's market soared 122.7 percent; Ukraine's market jumped 110.6 percent; and Mauritius's market catapulted 100.6 percent, according to Standard & Poor's data. The worst performer, Estonia, posted a 14.2 percent drop.

Such frontier market showings have sparked an array of responses: new frontier market indexes from Standard & Poor's and from MSCI Barra, more investment funds for these arenas, and a gush of money raining down on at least some of the markets.

According to data of EPFR Global, which tracks fund flows and allocations globally, net inflows from around the world into African regional equity funds hit $650 million in 2007, up from about $100 million the year before. Moreover, Middle East regional equity funds drew net inflows of $402 million last year, versus $130 million of outflows in 2006.

And this year through Jan. 23, funds for Africa-only, Middle East and Africa, and Middle East-only attracted $617.9 million in assets from investors worldwide, according to Brad Durham, mana­ging director of EPFR Global in Cambridge, Mass. That was all the more notable, he says, since "investors' sentiment has significantly deteriorated toward global equities overall."

To be sure, money flows have inflated some frontier markets. For example, as of December 2007, Vietnam's market had an astounding price/earnings ratio of 93.5, while Bulgaria's market had a 54.3 p/e ratio; Slovenia's had a p/e of 41.7; and Romania's had a 35.9 p/e ratio, according to Standard & Poor's. (In general, the higher the p/e, the more expensive the stock is relative to its fair value.)

African markets have also become pricier. Data from show, for instance, that the p/e ratios of the Zambia, Malawi, and Kenya stock markets stood at 21.1; 15.5; and 20.7, respectively, as of November 2007. By contrast they had p/e ratios of 5.8, 4.2, and 8.7, respectively, at the end of 2002.

Nonetheless, to some close observers, frontier markets remain a good story, amid the growth in their economies and companies. To Terrence Gray, portfolio manager of the DWS Scudder Emerging Markets Fund, "Although you always have to be selective in the stocks you buy, we're finding some very good companies, especially in the Middle East and Africa." As three examples, he cites Emaar Properties in the United Arab Emirates, Guaranty Trust Bank in Nigeria, and Zambeef in Zambia.

Moreover, Christian Deseglise, global head of emerging markets at HSBC Global Asset Management, believes "it's difficult to find a better asset class" than frontier markets. He cites such factors as the markets' high performances; returns that don't move in step with those of developed, or even emerging, markets; and much lower volatility than that of emerging markets.

But whatever the opportunities may be in frontier markets, options for tapping into them now appear limited for individual American investors. On one hand, signs show a growing number of frontier funds for institutional investors and wealthy individuals, requiring minimum investments of $100,000 or more.

Evidently, the T. Rowe Price Africa & Middle East Fund is now the only frontier-market mutual fund in existence for average investors, requiring a minimum initial investment of $2,500. Launched last September, that fund's assets now exceed $300 million, the company reports.

Individuals could also buy stocks in local markets, or they could invest in emerging-market funds with some frontier exposure. But according to some close observers, buying individual stocks in frontier markets can be costly and paperwork-intensive. And global emer­ging-market funds are likely to have limited, if any, exposure to frontier markets, some observers warn.

Whether more frontier-market mutual funds suitable for small investors will emerge anytime soon remains a debate. For his part, Joseph Rohm, an analyst for T. Rowe Price's Africa & Middle East fund, foresees "more product launches over the next year or two." He cites the rising interest – at least in the African and Middle East markets – as well as the growing "sophistication" of these arenas.

But John Chisholm, chief investment officer of Acadian Asset Management, doubts that many more dedicated frontier-market mutual funds for Americans will soon emerge. "Given the costs of operating in these markets and the fact that the markets [themselves] won't be getting huge, there's limited incentive for fund managers to offer dedicated frontier markets strategies," Mr. Chisholm holds.

And evidently the frontier markets themselves aren't ready for everyone to pile in. "The average [investor] in the US has so much money, and these markets are small," points out Mr. Deseglise of HSBC. "If you create billions [more dollars in investments], it could create serious disruptions" in frontier markets, he holds.

Although he finds frontier markets to be highly attractive, "this won't be a retail investment story for some time to come."

(Despite its name, data show that the exchange-traded fund, SPDR S&P Emerging Middle East & Africa fund, has more than 86 percent of its assets in the emerging markets of South Africa, Israel, and Egypt.)

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