2014 was set to be a fantastic year for frontier market investors. Up until September, the asset class had returned 30% to investors in euro terms, more than any other asset class during that period. But in a matter of weeks, the MSCI Frontier Markets Index lost more than half of that gain again (see graph below), reminding investors the asset class is very vulnerable to fluctuations in the oil price.
“This [the crash from November to mid-December] shows that frontier markets are essentially invested in oil-exporting countries in the Middle East and Nigeria, which makes them vulnerable to an oil price slump,” notes Tristan Delaunay, who leads Athymis Gestion, a fund-of funds boutique in Paris. “This could change as some of these countries are upgraded to emerging market status in the coming years, but for now frontier markets remain closely tied to commodity prices.”
Only for opportunists?
Overall, frontier market equity net inflows show a very high correlation with market returns. Frontier market funds enjoyed their highest net inflows in a year in October, just as markets had reached their zenith, suggesting a precarious timing by most investors. By November, net monthly inflows had plummeted by almost 95% to a mere €11.5m.
This investor response invoked memories of June 2013. At the time, Fed tapering talk provoked a flash crash in the asset class, with the MSCI Frontier Markets Index declining by over 12% in a month, and net fund flows by European investors plummeting from a record high of €268m in May to only €22.5m in June. Something similar also happened between November and December 2013, when net inflows dropped from €264m to -€74m with the index down 4.3% between November 3 and December 12.
Optimix, a wealth management company in the Netherlands with assets under management of close to €2bn, had an exposure of 3% to frontier market equities for most of its neutral mandates (and even slightly more for their riskier mandates) until early October last year. It was lucky enough to sell just at that moment, as asset prices had reached their peak though opportunistic investors were still pouring in money.
“Valuations were still attractive compared to emerging markets, but in our view this was just a liquidity premium,” says Jaap Bouma, a portfolio manager for the company. The frontier market universe has a total market cap of about $87bn, less than 3% of its emerging markets equivalent. “While liquidity is not much of a problem when there is a lot of appetite, it starts to bite when investors are looking for the exit,” says Bouma. And this is exactly what happened in the frontier markets in both May 2013 and November 2014.
Despite this volatility, it is useful to point out that frontier market monthly fund flows have, contrary to flows into emerging market equities, only been net negative on three occasions over the past three years. Fund selector sentiment shows a very similar picture. Though the number of fund selectors who say they will increase exposure can vary significantly, very few people say they will sell, which is consistent with the virtual non-occurrence of net outflows from the asset class.
We polled fund selectors across Europe on their views on frontier markets in early December. The results show that, as the frontier market downturn was in full-swing at the time, appetite had decreased considerably compared to early September. Only 16% now say they want to buy more, compared to almost one in three fund buyers a couple of months earlier. Appetite has declined most in Denmark, Finland, both countries where frontier market equities are a relatively established asset class, and Germany. But instead of massively retreating from the asset class, they rather stopped increasing their exposure.