How to access frontier markets at an affordable level of risk

In the last few weeks I have heard two comments about Nigeria. The first was from the chief investment officer of a UK pension fund, who said: “Nigeria is a place I’ve never been to; it sounds deeply scary.” 

I went twice to Nigeria last year. It’s different, but not scary. There is a very real risk of misconception.

That manager went on to say, of course, that investment is meant to be scary – “unless you feel uncomfortable you probably aren’t doing it correctly” – and emphasised the importance of specialist managers. The CIO was quite right on the latter.

The second was from the chief executive officer of a major institution in Africa, who said he wished the citizens of his country would show the same entrepreneurial zeal as those in Nigeria – on the drive from Lagos airport to Victoria Island you can buy pretty much anything from mobile phones, to lunch, to a refrigerator.

Frontier vs emerging markets

The frontier market story can be summarised as a rerun of the emerging market story. Frontier markets are where emerging markets were 15 years ago. But I would argue that they are much more robust thanks to the role of mobile technology.

Frontier market countries are a mixed bag. Simply allocating to all of them is the first risk to avoid. The second risk is taking a passive approach. Frontier markets require active investment. 

It is essential to have on-the-ground expertise in frontier markets

While frontier market indices exist, they are poorly representative as they are constructed from a small number of countries.

Emerging markets now show a correlation close to developed markets whereas the correlation for frontier markets is still low. A well-designed frontier market allocation shows no more volatility than emerging markets, but the low correlation means adding a splash of frontier markets will not increase risk at the total portfolio level.

It is true to say that investing in frontier markets is harder work than investing in, say, US equity – but the return expectations are correspondingly higher. 

Investing in frontier markets on the cheap is a big risk. But that is not an argument for not investing. The simple fact of the matter is that for a UK pension fund, salvation does not lie close to home.

Within frontier markets I am going to focus on Africa, excluding South Africa. Its 54 countries – containing a seventh of the world’s population and a vast land mass – represent a significant component of frontier markets, especially as certain Middle East countries have been reclassified as emerging. 

Africa is buzzing – finally, change for the better is happening and happening fast. These characteristics mean a single-manager approach represents risk. 

It is far better to spread the load across several managers, some with pan-Africa focus and others with regional, or even domestic focus. Nigeria may be the big player in western Africa but its colonial heritage is British, whereas for many of its neighbours it is French. 

It is essential to have on-the-ground expertise in frontier markets. The combination of small allocation at the total-portfolio level and the need for several managers points to a multi-manager approach.

Such construction leads to a portfolio no different in volatility than emerging markets and hence provides access to frontier markets at an affordable level of risk.

Yes, a multi-manager arrangement will be more expensive than a single fund – but then there is a lot more going on under the bonnet that is essential for successful investment. And the fee is easily outweighed by the expected return.

Finally, frontier markets are not close to home, and perspective can be different. Private equity in a frontier market like Africa is not seen as an alternative, as is the orthodoxy for a UK pension scheme. Rather it is seen as an integral way of investing in equity, as there is little, if any, use of debt. An equity investment should therefore consider both listed and private forms of equity.

Andrew Slater is UK managing director at RisCura