Welcome to the new frontier
Emerging markets may still be hotter than a freshly-baked biscuit, but to some asset managers they are already yesterday’s soggy leftovers. No, for the real adventurer, frontier markets are where it’s at. These markets may be shallow, illiquid, or hedged around with foreign ownership restrictions, but the prize for finding the next BRIC is just too good to pass up.
Of course, there are a lot of small markets out there, and some may just trundle on for years without industrialising. So how do you decide which to target? Well, Credit Suisse Research recently developed an index to identify key global frontier markets and resolve this conundrum.
Credit Suisse argues that whilst the BRIC countries represented just 4 pct of global market cap at the end of 2003, this figure has now risen to over 14 pct, which is more or less equivalent to their share of global GDP. At the same time, their valuations have risen. “Emerging markets used to trade at a 50 pct discount to developed markets five years ago, but this valuation gap has now almost closed,” says Lars Kalbreier, head of global equities and alternatives research at Credit Suisse. “Furthermore, in regions such as Asia ex-Japan, some emerging markets are now starting to trade at a premium relative to developed markets.”
Indeed, some countries that are still generally referred to as emerging markets, such as South Korea and Taiwan, now have a very similar economic profile to developed countries, and have arguably emerged. Kalbreier points out that Korea has a GDP per capita that is higher than those of Greece or Portugal, and computer ownership per head is higher than in Italy.
Instead, Credit Suisse argues that investors should be looking at countries that are still at an early stage of development, as many of these markets have been overlooked or difficult to access. “In order to be successful, investors have to identify those markets that demonstrate the same characteristics as the traditional emerging markets did before they improved their economic status,” it says.
Credit Suisse’s index selects frontier markets according to the following criteria – macroeconomic potential, population well-being, financial market development and political stability. It includes African states Botswana and Tunisia, LatAm’s Peru and Colombia, one-time investor darling Vietnam, and former Soviet republics Ukraine and Kazakhstan. S&P’s similar Select Frontier Index also finds room for Cambodia, Pakistan, Panama and the UAE.
Favourite frontiers
Managers cite the diversity of this asset class as a hedge against volatility, but certain markets come up again and again. The unlikely-named Ho Chi Minh Stock Exchange has seen frenzied activity from foreign investors in the last 12 months, as its low cost base is viewed as attractive to manufacturers who worry that Chinese inflation will erode their margins.
“Although Vietnam still has a communist government, the leadership seems open to business and keen to emulate the kind of rapid development they’ve seen in neighbouring countries,” says Giles Keating, global head of research for private banking and asset management at Credit Suisse. But as Keating warns, there are risks attached to this market, and those risks need to be reflected in an attractive price. “The market has fallen back a little recently, which is good news in terms of putting new money in as it offers a more attractive entry point, but there are moments when Vietnam looks as if it has attracted a bit too much investor attention,” he says.
Whilst too much attention can make a small market swell too quickly, too little activity also poses problems for frontier pioneers. Andrea Nannini, manager of the HSBC New Frontiers Fund, which launched at the start of February, has a three-year track record in these markets and is used to sourcing stock through different channels.
“The liquidity in these markets is still poor, particularly in Sub-Saharan Africa, where some stocks don’t trade less than 100,000 usd a day,” he says. “In such a case, you have to establish relationships with a few of the local players and find brokers or investors with blocs of shares that they are willing to sell, and negotiate terms with them.”
He adds that liquidity has improved in the Gulf states and some of the former Soviet satellites as more foreign investors are operating in these markets, so the turnover is higher. “Also, there has been a high number of IPOs in the last couple of years with more companies coming to market, and in 2008 and 2009 the pipeline looks very big.”
Foreign ownership quotas
Another problem in accessing these markets is that there can be restrictions on foreign ownership levels. “The Middle East does have quotas on what percentage of the share capital can be owned by foreign investors,” confirms Nannini. “There are a few stocks where the limit has been reached and in those cases there is not much you can do, but a number of companies have gradually increased their limits and that is definitely the trend.”
He predicts that in a few years most of the restrictions will have been removed, especially in the case of the non-government related companies. For markets like Saudi Arabia, which is still closed to investors, the only approach is to buy local mutual funds or synthetics on the whole index.
The recent turmoil in Pakistan and Kenya is a reminder that political risk also remains an issue, but Nannini argues that investing across a variety of countries and regions helps diversify this away. For example, in January, the segment as a whole was flat, whilst everything else was down by 15 or 16 pct. “This is because although Kenya and Pakistan were going down, the Gulf states and Nigeria were going up, so this lack of correlation within the asset class is a very strong proposition.”
He sees the main risk to frontier markets this year coming from commodity prices because most frontier markets are also big commodity producers, and relative to the size of their economies, commodity prices matter. However, he thought it unlikely that commodity prices would fall back to the levels of 2001 or 2002, at the beginning of the rally.
Ultimately, it comes down to good corporate governance and clued up management, and Nannini says he makes sure he travels as much as possible to be as close as he can to the companies: “This how you find interesting ideas – going places where no one has gone before.”
If you want to read more about life at the frontier, please go to:
http://www.thomsonimnews.com/story.asp?sectioncode=7&storycode=36392
Testing times
The rationale for 130/30 funds is seductive. The idea is you get a lot more return for just a little more risk, but since their launch they have been attacked for being neither fish nor fowl – indeed, the most popular criticism is that they offer the “worst of both worlds”.
2007 provided an opportunity to see how this relatively new concept would stand up to adverse conditions – and the quant models found it rough riding. By contrast, their fundamental counterparts were able to adapt to the tougher macro environment more easily.
Generalisation in this market is difficult, but broadly speaking, 130/30 quant funds use a mechanistic ranking process based on the computation of historical data; have full market coverage; benefit from market breadth; and take a large number of small bets. They also rely on back-testing – but there is no testing like live market testing.
Their fundamental equivalents rely on a qualitative investment decision process; concentrate on their top conviction ideas; can benefit from skewed indices; and take a small number of large bets. Fundamental manager Peter Lees, head of UK equities at F&C, argues that quant 130/30 is wasteful and dilutive in that a common approach is to replicate the entire index first and then add 30 pct of longs and 30 pct of shorts.
“If you recreate the index first then you are not putting on a proper short, because it is still represented in that initial 100 pct,” he says. “Also, you are reproducing the long and wasting capital.”
He adds that as the FTSE All-Share is a very concentrated index, managers are effectively shorting the bigger stocks by not owning them. “The top 15 companies make up nearly 50 pct of the benchmark and about 75 pct of the index is made up of only 50 companies.” Beyond this there is a long tail of tiddlers. “The question is how many positions do you need to take to get a full diversified portfolio whilst keeping volatility to an acceptable level?”
Mark Webster, senior investment manager at SSgA, one of the leading quant 130/30 managers, says that SSgA’s approach does vary from market to market depending on the target audience and whether derivatives are allowed. “In some countries there is stamp duty and you can avoid paying this by using derivatives. This is particularly the case in the UK market, where we use a single swap. We go long 130 pct and short 30 pct and it’s all considered one investment, relating to the underlying holding.”
He argues that fundamental managers have a process that tends to only identify the very best stocks, rather than ranking all the stocks in an index and gaining from the spread between best and worst, like a quant manager. “The quant approach typically involves looking at different characteristics of stocks and ranking companies from top to bottom within their sectors. We do this across all sectors in the index and then pick the top 20 pct ranked companies, plus some from lower down in the rankings for portfolio diversification reasons to reduce the risk,” he explains.
“But the reason why 130/30 is better than long-only is because it allows us to identify the worst companies in the index and go short. Many of these companies have small index weightings so in a long-only fund you would not be able to take a proper position on the negative side. With this approach we get an extra spread between the best and the worst, by shorting the stocks we don’t like.”
Webster stresses that SSgA operates on an industry neutral basis – it doesn’t take big weights in sectors or big deviations away from the benchmark. 2007 produced such a broad range of returns because those houses that called the sectors right – for example, going heavily underweight financials, and heavily overweight tobacco stocks – gained disproportionately due to the magnitude of the moves. “So there have been some houses who may have done nothing for years who have done quite well.”
Conversely, quant managers had a difficult year, partly due to the M&A cycle, and partly due to the credit crunch: “There was a lot of venture capital money that was coming in and they weren’t really paying much attention to valuation metrics because of the cheap financing that was available,” he says. “The other problem relates to when you have a big change in expectations but not a big change in reality.”
Webster explains that August’s credit crunch triggered a change in the perception of how the economic cycle was going to turn out which meant that stocks were sold indiscriminately, hurting those with systematic models. However, a rapid change in expectations will be followed by a slight lag as accounting data and other inputs catch up. “It will take a little while for analysts to update their forecasts. The benefit with a quantitative model is when you get a change in expectations but nothing follows through. Whilst you might underperform for a month, if you don’t do anything radical with your portfolio you avoid a lot of false dawns.”
Given that quant funds struggled in 2007, and higher market volatility looks set to stay, how might this strategy develop? Andrew Barber, global head of manager research at Mercer, says that 130/30 has attracted a lot of interest in the UK and Europe but it has been more successful in pulling in funds in Australia, Japan and the US. Meanwhile, more fundamental managers are waiting in the wings.
“There are some 130/30 products in the UK but they are not huge in volume,” he says. “I think a lot of fund managers are running paper 130/30 strategies or live ones with small amounts of seed capital to see if they can short successfully. In a year or so, maybe those that have worked will come out of the woodwork, and those that don’t will die a death. But then you have to be wary because the ones that reach the market will represent survivorship bias.”
As well as traditional fund managers, there is also the possibility that more hedge funds will come into this space in an attempt to reduce their volatile earnings streams. “Hedge funds are very opaque and haven’t performed well recently – they are now 95 pct correlated with the S&P because there are too many of them and not enough diverse strategies,” asserts F&C’s Lees. “They know how to short but they don’t know institutional investors, so it is possible they will offer high alpha, scaleable 130/30 strategies to attract institutions and get the volatility of their earnings under control.”
Barber strikes a note of caution, however: “Some hedge funds are interested in institutional money, but they will want higher fees than the traditional managers offering 130/30. Also, you’ve got to question their motivation for doing it,” he points out. “How much money can they really manage without their dealing costs getting in the way? And if they’re trying to get into 130/30 products does that mean they can’t sell their long/short products because they’re not good enough? Why would they want to eat up capacity in a lower margin product?”
If you want to read more about how quant 130/30 managers are revising their models in the light of 2007’s performance, please go to:
Battling Asian flu
Asian markets proved remarkably resilient last year, despite the problems in Western markets, ending 2007 up by around 30 pct. But in January, as a US recession loomed and panic spread, mass sell-offs saw the MSCI EM Asia fall just over 14 pct, as foreign investors sprinted for the exits.
“The fear is that if there is a recession in the US and Europe, Asian growth will be in trouble,” says Khiem Do, head of Asian multi-asset at Baring Asset Management, speaking at the time of the sell-offs. “This correction isn’t pleasant but this is the impact of the concern over the US recession. It is a nasty bug that is going around.” However, some markets, such as the China A-share market, Malaysia and Singapore, held up better than others through the turbulence.
Mike Hanbury-Williams, F&C’s head of Pacific equities, points out that although Asian stocks can experience volatility of 20 pct in one day, there is no real volume in these prices. “It’s often relatively small volumes that are sending prices downwards. When we buy in we see the stocks bounce back.”
Indeed, Asian markets have subsequently attempted to rally. “This suggests they may be able to withstand the cold winds of a US recession, if it is not too severe,” says Do. “Asian exports will fall but that won’t be disastrous as Asian exports to the US have fallen quite dramatically over the last 10 years, and intra-regional Asian trade has increased.”
Despite the argument that there will be few upside surprises to China this year, and the fear that it is getting a little toppy, Do said that it remained a good growth story and the valuations amongst the Hong Kong-listed China stocks were still cheaper than those in India. “But India is building a lot of infrastructure to modernise its industries and cities, and the growing middle classes are upgrading their homes. In China we can see the government trying to push the growth westwards, as Shanghai, Beijing and Guangdong are all in the east, and that requires a lot of spending on infrastructure.”
James Weir, investment analyst for the Atlantis Asian Recovery Fund, is more cautious, predicting a short-term pull back in India, in a longer bull market. “Things have gone quite far, quite fast in India, but it benefits from the requirement for infrastructure, which is gigantic. There are also a lot of power company IPOs coming up in the first quarter, and there will be a tremendous demand to build plants and for coal to fire these stations.”
He also thinks that China looks overbought in the short term: “It has had a tremendous run, and a correction is now underway. The fundamental story remains but the government has to balance out the flows, whilst inflation is still very strong, and interest rates need to increase. So it’s all about how well can they manage inflation in a market economy. If they manage it badly there’s an event risk to the equity market.”
Indeed, in India attempts have been made to clamp down on some of the hot money coming in, but China and Hong Kong have seen a massive run up in their markets driven by domestic retail investors. “The government is trying to manage the process of getting that liquidity from the A shares market into Hong Kong and other markets in Asia, but there’s a phenomenal amount of money in China waiting to come out,” says Weir.
The problem is that with currency controls in place, Chinese investors can’t just buy Hong Kong ‘H’ shares if they want them. A lot of the flows have been into mutual funds, but there are quotas on the amount of money that can come out of China, and the markets that it can go into. “No one wants an absolute tsunami of cash coming out of these markets in an uncontrolled fashion, but domestic Chinese investors will have an enormous impact on the Asian equity markets over the coming years,” Weir adds.
If you want to read more on which markets are expected to do well in Asia this year, please visit:
http://www.thomsonimnews.com/story.asp?sectioncode=&storycode=35200
