Welcome to the Exotix Blog! In our inaugural post, we publish the first in a two-part series delving deeper into the crisis of identity and confidence afflicting many in frontier and emerging markets.
We have not encountered such a lack of confidence in the investment process, the definition of the investment mandate or the choice of benchmark equity index in our institutional clients in over a decade of conversation with them. This is our impression after the three months of meeting over a hundred individual fund managers and analysts.
This is particularly striking given that there is consensus that the markets they invest in, whether notionally termed ‘frontier’ or ‘small emerging’, are, in general, very attractively valued and the global environment is supportive.
Here, we examine why frontier and small emerging countries are of interest in the first place. Surely not because of the potential to arbitrage upcoming benchmark index constituent changes! But, rather, because, in the long term, the opportunity for better returns than seen across developed markets should be driven by:
(1) Faster growth in per capita GDP than that seen in developed countries (economic “convergence” as property rights are better protected, human, physical and financial capital is more efficiently mobilised and new technology spreads across borders).
(2) For equity investors specifically, by generally, less sophisticated and liquid markets (which create the opportunity to invest in very good companies at prices that insufficiently reflect their outlook in advance of these markets becoming more discovered, accessible, liquid and efficiently priced).
For those without conviction in these core drivers of the long-term opportunity (or for those concerned that multinationals listed in developed markets will gobble up the opportunity and are still at attractive equity valuations) this is not an attractive asset class. For the rest, there are three implications:
(1) The tyranny of existing benchmarks needs to be jettisoned; at least until the providers of those benchmarks do a better job of composing benchmarks more reflective of these two core reasons for investing in these markets in the first place.
(2) The rich emerging markets (e.g. with GDP per capita above US$15k) perhaps should not be included in the addressable universe (this would exclude markets such as Chile, the Czech Republic, Greece, Hungary and the GCC) because they are less likely to exhibit convergence growth characteristics.
(3) Equity funds focused on these markets should not offer the same liquidity (ease of redemption) as those in developed and the large emerging markets. How can markets with a fraction of the average daily traded value of developed and the large emerging markets support the same redemption terms? Given that outperforming frontier and small emerging markets tend to enjoy relatively greater liquidity, a fund focused on this asset class tends to be forced to sell its best-performing stocks in response to a redemption; a counter-productive quirk.
Coming up: Frontier-Emerging strategy – a crisis of confidence in the process, rather than the opportunity.
Are Frontier and Emerging markets going through a crisis of confidence? Let us know your thoughts below.