By Andrea Hopkins
Oct 7 (Reuters) - After a year of mediocre returns fromemerging markets, many investors are searching for yield inso-called frontier markets in hopes that low prices andpotential growth will outweigh the risks in little-developedlands.
Often viewed as tomorrow's tigers, nations like Nigeria,Qatar, Bangladesh or Colombia have drawn interest from assetmanagers looking for well-managed companies serving a growingmiddle class - a combination with strong potential for profit.
"It really is one of the most interesting asset classes,"said Gavin Graham, chief strategy officer at INTEGRIS PensionManagement Corp in Toronto. "There are very few markets leftthat are not correlated to major asset classes. With rateshaving gone so low, everything moves in one direction. Frontiermarkets don't."
Graham said every investor who owns international equitiesshould look at boosting exposure to frontier markets, especiallysince aging emerging market stars like China, India and Brazilhave become more correlated to developed nations, nullifyingtheir appeal as high-growth performers.
Since the start of 2012, MSCI's Frontier Market index has risen 20.1 percent, nearly triple theperformance of stocks in its emerging market index,which climbed 7.0 percent.
Dividend yield is also above 4 percent, almost double the2.5 percent for global equities, while typical price-to-earningsratios are lower, because share prices are relatively cheap.
Frontier companies and countries are also often far lessleveraged than those in the developed world, making risingglobal interest rates less threatening.
"Typically people have been going to emerging markets beforethey have looked at frontier markets, so they have really beenoverlooked," said David Kunselman, senior portfolio manager atMississauga, Ontario-based Excel Funds Management, whichspecializes in emerging markets.
HIT HARD IN LAST CRISIS
The potential rewards from frontier markets come with highrisks. During the last financial crisis, MSCI's InternationalFrontier market index lost about two-thirds of its value ineight months. And it is still only worth a little more than halfof what it was in early 2008.
Excel Funds does not have a frontier fund, but it will,Kunselman said. "We like these countries. To us, the frontiermarkets are almost emerging markets, 10 years beforehand. Theyare the next emerging markets."
A new fund would likely be welcomed in what is a relativelyilliquid investment sector without a lot of options. Onehigh-profile fund, the Templeton Frontier Markets fund, closed to new investors in June, citing a surge inmoney.
"While the Templeton Emerging Markets Group does not see anycapacity issues within the frontier markets universe, the softclose is a way to best manage the flows coming into thededicated frontier market portfolios," spokeswoman Sarah Kingdonsaid in an email.
While the market may be relatively overlooked, a surge ofmoney may inflate prices too quickly and push investors intosecond-tier companies as they look for new bargains.
FOREIGNERS WITH A CHECKBOOK
Along with some U.S. and European mutual funds in frontiermarkets, a handful of exchange-traded funds (ETFs), includingthe BlackRock Frontiers Investment Trust have alsoinvested in the sector.
While the lower costs of ETFs boost their value in developedmarket assets, that may not work for frontier markets. Grahamsaid paying the fees for active management has paid off infrontier markets, even with management expense ratios (MERs) atabout 2.1 percent.
"Even after those MERs, they still manage to beat the(frontier) index" said Graham, whose book "Investing in FrontierMarkets: Opportunity, Risk and Role in an Investment Portfolio,"co-authored with Al Emid, was released last month.
"With frontier markets, the quality of the information youare getting is not particularly great, so you have to be basedthere, or at least traveling frequently ... to kick the tires,see the management," Graham said. "Otherwise you risk being seenas the stupid foreigner with a checkbook."
While some investors might balk at investing in nations likeArgentina, Egypt or Pakistan, which are strife-ridden andunstable, many asset managers see volatility rather than risk.
Thomas Vester Nielsen, frontier market portfolio manager atLloyd George Management (LGM), a unit of Bank of Montreal, said the beauty of holding 40 equities in two dozenless-developed countries is that they have no correlation witheach other. Problems in Georgia may not touch Cambodia, andstrife in Kenya is not likely to affect shares in the UnitedArab Emirates.
That effectively diversifies a portfolio, a welcomedevelopment in a global market in which a default in Europe or amonetary policy shift in the United States can drive downequities, bonds and commodities in one afternoon.
Holdings in LGM's Frontier Markets Strategy portfolio rangefrom Vietnamese milk producer Vinamilk to Nigeria's GuarantyTrust Bank and Senegalese telecom Sonatel.
And given the liquidity question and volatility, a long-termapproach is critical.
"Ten years plus. This is what you consider for yourretirement funds or kids' college funds," LGM's Vester Nielsensaid. "Take a cornerstone of your portfolio and you leave itaside with a long-time horizon, not money you depend on in theshort run."
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