Frontier markets have significantly outperformed emerging markets on a three-year view, while the former has also beaten the latter in the past two full calendar years.
The likes of Nigeria, Pakistan, Vietnam, Botswana, Kenya, Estonia and Vietnam have delivered strong returns to investors over this period while emerging market stalwarts such as China, Brazil and Russia have experienced substantial headwinds and sell-offs.
The end of QE in the US, currency fears, slowing growth in Asia and various geo-political fears have all contributed to a gloomy outlook for emerging markets. This year has also seen a huge swathe of elections across emerging markets and, bar India, the results have not been interpreted favourably by international capital flows.
According to FE Analytics, the MSCI Emerging Markets index has gained 15.14 per cent over the past three years compared to a gain of 50.83 per cent in the MSCI Frontier Markets.
Performance of indices over 3yrs
Source: FE Analytics
Shah, whose £250m Advance Developing Markets investment trust invests across both emerging and frontier markets, is bullish that the high returns in the more volatile subset of emerging markets will continue to give investors a greater return.
“On a relative basis frontier markets are looking more favourably over the medium despite higher valuations,” he said.
“Frontier markets have a greater trend of urbanisation and young demographics.”
In particular, Shah says he backs Nigeria more than any other frontier market over the medium term.
The country has witnessed a sharp sell-off in recent in months, losing almost 20 per cent in six weeks. Sentiment has plunged following a similar fall in the price of oil, a key export for Nigeria.
Performance of indices in 2014
Source: FE Analytics
However, Shah says there remains a strong case for the country due its demographics of a young population with a rapidly expanding middle class and course of urbanisation.
Both emerging and frontier markets have demonstrated considerable volatility in recent years with the ‘tapering’ of QE in the US being the most recent culprit of heightened volatility.
Two ‘taper tantrum’ sell-offs have occurred over the past 18 months as investors jettisoned exposure to risk assets over fears the end of loose monetary policy from the Federal Reserve will spell difficulty for emerging markets used to cheap money.
The first sell-off occurred in May 2013 when the taper was first hinted, with the second occurring at the start of 2014 when the tapering policy actually began.
The likes of Gerardo Rodriguez Regordosa, managing director of emerging markets at BlackRock, has warned investors that emerging markets funds with a higher exposure to frontier markets are most at risk from a global economy where the QE tap has been turned off.
“When you invest in frontier markets you get very interesting demographics and you get countries that are at an earlier stage in terms of income per capita development and a lot of exposure to natural resources.”
“That explains some of the dynamics of frontier markets recently and their outperformance this year. However, investors need to be mindful of this as the cycle of monetary policy continues, especially as frontier markets do not look as cheap as they did because of the nice run that they have had.”
Most frontier funds have been outperforming the vast majority of funds in the IMA Global Emerging Markets sector in 2013 and 2014 so far.
For example the $1.9bn Templeton Frontier Markets fund has returned 47.02 per cent over the past three years while the MSCI Frontier Markets index is up 50.83 per cent.
Performance of fund, sector and index over 3yrs
Source: FE Analytics
This year no fund in the IMA Global Emerging Markets sector has kept up with the MSCI Frontier Markets index.
In a recent FE Trustnet article Hawksmoor’s Richard Scott and Premier’s Simon Evan-Cook said they have both been selling down exposure to frontier markets due to concerns over the future stability of the asset classes’ recent high returns.
Scott “reluctantly” sold his exposure to the $1.6bn Schroder ISF Frontier Markets Equity fund due to its strong returns and because he is concerned about future liquidity problems in that part of the market.
Evan-Cook, meanwhile, is retaining some holdings but has locked in profits following this year’s strong performance.
“We still hold them, but we cut back our weighting quite significantly around two months ago. The reasons why are very similar to Richard Scott’s, which are that valuations aren’t as attractive as they have been and a lot more money has gone into the asset class recently,” Evan-Cook said.
“We still hold frontier markets but they will always only ever be a satellite holding. They are useful as they give you access to fast growth areas and to companies you wouldn’t have exposure to though other funds.”