Over the past three years, the MSCI Frontier Market Index has undergone a radical shake-up: three of the largest constituents (Pakistan, Qatar and the United Arab Emirates) have been promoted to emerging markets status, while two other prominent constituents (Argentina and Nigeria) may also soon be out of the index.
It would be too much to ask from fund managers to demand from them to reflect these changes in their funds instantly.
In fact, all frontier market equity funds for sale in Europe now have sizeable allocations outside the frontier markets index.
The Schroder ISF Frontier Markets Equity fund, for example, holds companies listed in Pakistan, Egypt, the United Arab Emirates and Saudi Arabia, none of which are represented in its benchmark MSCI frontier market index.
If MSCI decides to promote Argentina (which has a 19% weighting in the fund) to emerging market status as well later this week, well over half of the exposure of the fund will be outside frontier markets.
Wouldn’t this be a problem for investors, not least since the fund charges a 15% performance fee based on its relative performance versus the MSCI Frontier Markets Index?
After all, the make-up of the fund does not anymore reflect the current frontier market universe.
Not necessarily, believes Alvaro Martin Sauto, head of funds-of-funds at the Spanish bank Bankia, who is invested in the fund.
“The fund still gives us exposure to frontier markets, and if they are still trying to beat that index with a high tracking error that is fine for me,” he says.
“We also own the Templeton Global Bond Fund, which uses a global benchmark but has a strong bias to emerging markets. We don’t find that a problem either, as long as the manager does a good job.”
Martin Sauto’s flexibility is partly driven by his understanding that it has become almost impossible to run a pure play frontier markets fund, especially when it’s the size of the Schroders one.
With assets of almost $1.5bn (€1.34bn), it’s the largest frontier market equity fund for sale in Europe. The frontier market index has a total market cap of only $116bn.
“It’s difficult to keep seeing frontier markets as a differentiated asset class, with so many countries being promoted to EM status,” the Spaniard concludes.
Andrew Brudenell, manager of the Ashmore Emerging Markets Frontier Equity Fund, has tacitly accepted that large chunks of his fund are now part of the EM index rather than the frontier index, and he doesn’t see it as a problem either, yet.
“We don’t invest in an index. Instead, we aim to provide our clients with an allocation to companies they otherwise would not have exposure to,” he says.
A country like Pakistan returning to emerging market status doesn’t mean it has become a mainstream investment destination all of a sudden.
“Pakistan is still considered a scary place by most people. I predict it will remain represented in our portfolio for a long time to come,” Brudenell adds.
The Finnish asset manager Evli takes a more radical approach to the issue, which may be a way forward for other frontier fund managers as well.
The Evli Emerging Frontier Fund invests, as its name suggests, in both frontier and emerging market securities and has no benchmark.
“It’s a good question whether frontier markets actually deserve to be a separate asset class,” says Tanja Wennonen-Kärnä, senior portfolio manager at Evli’s private banking arm, who invests in the fund on behalf of her private clients.
The attraction of frontier markets indeed is in the fact they are perceived as different and exotic, confirms Wennonen-Kärnä.
“It’s an opportunistic play in a small part of the portfolio,” she says.
And, says Bankia’s Martin Sauto, an important part of the attraction of frontier markets also is the possibility for these markets to make a promotion to the larger emerging markets index, as Pakistan did last month.
Such a promotion presumably leads to fresh inflows from both active and passive investors, driving up share prices.
By widening the mandate of a frontier fund to include emerging markets, one retains the benefits of frontier investing, while avoiding the pitfalls of excessive concentration, liquidity shortages, and having to reshuffle your allocation each time after each index review.
In practice, frontier market fund managers already have sizeable allocations to emerging markets, but most have so far failed to change the description on the tin according to this new reality.