Big catches may be in frontier markets

Investing in emerging markets isn't optional anymore. Globalisation means that countries once thought of as marginal are central to any smart investment plan.

What's still optional - for now, at least - are markets characterised as "frontier". Frontier markets are young and thinly traded, with small numbers of stocks, poor regulation, unreliable financial reports and low levels of foreign ownership. In other words, mystery markets. But, like travel, they broaden the mind.

Who's on the frontier? Ukraine, Cyprus, Estonia, Kuwait, the UAE, Ghana, Nigeria, Ivory Coast, Ecuador, Jamaica, Kazakh-stan, Vietnam and perhaps two dozen more. Investment managers group them under acronyms: Mena, for Middle East North Africa; EMEA, for Europe (specifically, eastern Europe), Middle East and Africa.

Several indexes track these new markets. The S&P Frontier Markets Index covers 24 countries, including seven African states but none of the oil states in the Middle East. For the oils, check a smaller S&P index called Select Frontiers Total Return Index.

MSCI Barra launched a 19-country index last November, dominated by the five oil states whose markets are open to foreigners (that excludes Saudi Arabia). Merrill Lynch added its own 17-country index in March, the Merrill Lynch Frontier Index, also dominated by oil.

Common themes

Each frontier country has a slightly different story with the common investment themes.

There's the commodities boom - oil, of course, but also metals and agriculture. The consumer explosion - rising urban middle classes snapping up cellphones, cars, television and appliances. Infrastructure - the International Monetary Fund has forgiven much of Africa's debt, leaving these governments with surpluses to invest in electricity, telecommunications and roads. Finance - with lenders prospering. Construction - offices and apartment buildings, airports and shipping facilities.

Asset managers are pitching these markets as "uncorrelated" with those of the more developed world, meaning that stock prices there run on different tracks. They may rise when the more familiar markets are going down. In truth, however, we haven't had enough experience with frontier markets to declare them a potential cushion for bad times.

A more compelling reason to own them is, simply, globalisation. Modern commercial and consumer cultures are being created in places they didn't exist before.

The economic drivers include new trading patterns, the movement of manufacturing jobs to lower-wage countries, high commodity prices, privatisation of government industries, growth in the pools of local investors, direct investment in frontier countries by foreign pools of capital (especially from China) and political and capital-market reforms. "They're where the emerging markets were 10 or 15 years ago," says Fahmi Alghussein, Morgan Stanley's head of distribution in Dubai. Economic growth rates are running at five per cent and up, twice that of the developed world.

Antoine van Agtmael, chairman of Emerging Markets Management LLC in Arlington, Virginia, has been investing in Africa for 14 years. Returns, he says, have been four times those of the traditional emerging markets. "A few years ago you could buy Unilever Nigeria or Guinness Nigeria for peanuts," he says, "and they're well-managed companies with great products."

Disappearing freebies

Freebies like that are largely gone. The big promise, van Agtmael says, lies in the thousands of other companies ""operating under the waterline,'' not yet noticed by the published frontier-market indexes.

Not that everything is rosy along the global frontier. Vietnam's bubble ended this year in tears.

There's political risk, such as the blowup after the elections in Kenya and the risk that the boom in commodity prices slows. Electricity shortages are damaging growth south of the Sahara. Small changes in cash flows can have a huge impact on markets because they're so thinly traded.

Some frontier markets have gone very badly, says Michael Reynal, portfolio manager for Principal Global investors, an asset-management firm based in Des Moines, Iowa. "Venezuela was once the darling of emerging markets and it is just barely coming out of a grueling period," he says.

The advent of frontier-market indexes means that exchange-traded funds won't be far behind. Claymore has filed with the Securities and Exchange Commission to create the first one to trade in the US - the Claymore/BNY Frontier Select DR Index Fund, tracking a Bank of New York index of 26 companies in 11 countries. Whether it attracts enough business to become a profitable product for Claymore remains to be seen.

At present, the best way to invest is through T. Rowe Price's new Africa & Middle East Fund, a no-load (no sales charge) fund, with a $2,500 minimum investment and an annual cost of 1.92 per cent. Joseph Rohm, vice-president of London-based T. Rowe Price International, likes the Gulf oil states and Nigeria, Ghana, Uganda, Egypt, Zambia and South Africa.

"We don't have to compromise in terms of the companies we're selecting," he says. "They're high quality in a global context. You're seeing some of the African diaspora returning home, bringing with them experience and management skills."

I wouldn't want to kid you. It's an investment for crazies. But for money you'll ignore for the next 15 years, well, why not?