One of the main advantages of investment trusts over their open-ended counterparts is that the permanent pool of capital allows them to invest in less liquid holdings that could otherwise be difficult to access. This is because in the normal everyday course of business they would never be forced into selling the assets to fund client redemptions. We have seen the benefit of this with direct property trusts in the wake of the Brexit vote, but it also applies to other areas such as the Frontier Markets.
The appeal of Frontier Markets
Investopedia defines the Frontier Markets as “countries with investable stock markets that are less established than those in the emerging markets“. They are also sometimes referred as “pre-emerging markets”.
It would be easy to dismiss the Frontier Markets as a step too far and just concentrate on the more established Emerging Markets, yet the data suggests that this would be a mistake. Analysis by Winterflood Securities shows that over the 5 years to the end of March the MSCI Emerging Markets Index returned around 32% with annualised volatility of 16.5%. During the same period, the MSCI Frontier Markets Index generated just over 70% with an annualised volatility of 12%.
One of the best ways to gain exposure to this area is the BlackRock Frontiers Investment Trust (BRFI). Since it was launched in December 2010 it has achieved an impressive NAV total return of 80%. This was well ahead of the 45% returned by its MSCI Frontier Markets benchmark, and the Global Emerging Markets sector average of 27%. It also has a high dividend yield of 3.4%.
How is the fund defined?
BRFI’s mandate defines Frontier Markets as those countries that were not members of the MSCI Emerging Markets Index or the MSCI Developed Markets Index at the start of December 2015, although it can also invest in Colombia, Egypt, Peru and the Philippines. If any of these countries are upgraded to developed market status the managers are required to sell the associated stocks ‘as soon as reasonably practicable’.
In theory, fund managers can can invest in about 140 different countries, although many of them are considered too small or unstable to deal with. The reality is around 30 or 40 investible countries. These typically have a low correlation with each other and with the more developed markets as returns are mainly driven by domestic issues, which makes them a valuable diversifying holding to have alongside more traditional asset classes.
Sam Vecht and Emily Fletcher, the fund managers, believe that the Frontier Markets offer an opportunity for strong long-term returns. This is because the stocks are often under researched and there is potential for high economic growth, and increased investment in their capital markets.
Analysis by Winterflood Securities shows that of the fund’s top ten country allocations at the end of January, six had forecast GDP growth rates of more than 3.5% for 2017. Only four out of the top ten countries in the MSCI Emerging Markets Index were expected to achieve this sort of growth with none in the MSCI World top ten.
Many Frontier Markets have low levels of government debt to service and the demographics tend to be favourable due to the growing working populations. Most also benefit from the presence of natural resources that should help to finance their economic development.
Despite these attractions, relatively little money has been invested in this area – Frontier Markets funds only account for around $17bn of the $1,425bn invested in the wider Emerging Market peer group. The managers think that these countries have been overlooked by most institutional investors and that this lack of research creates the opportunity for them to add considerable value.
How the portfolio operates
Vecht and Fletcher aim to invest in cheap currencies and cheap stock markets without taking on any undue risk. Once they have identified the most attractive countries they then look for local companies that have decent growth potential with the main focus being on the cash flows and the quality of the management.
The managers spend a lot of time in the Frontier Markets meeting a wide range of influential people. This includes not just the management teams of potential investee companies, but competitors, suppliers and local politicians. They will only invest if they are satisfied that the fund’s assets are safeguarded to a sufficient degree.
One of the main risks of operating in these markets is poor corporate governance and in order to mitigate this the fund will only look at companies that are fully audited, with the majority of the holdings having appointed a subsidiary of one of the big four accounting firms. The managers also insist on visiting each company before they invest.
At the end of February the portfolio was spread across 29 different countries with the largest exposures being: Argentina 14%, Kuwait 10%, Romania 9% and Pakistan 9%. There are normally between 35 and 65 holdings with the top ten making up about a third of the assets according to the latest available data.
These allocations can change quite frequently in order to take advantage of the best opportunities as they come along, which explains the high average annual turnover of 96%. The managers’ current preferred options include Kuwait, Vietnam and South America.
The size of the investment in any given company reflects both its upside potential and the liquidity. All of the holdings in the portfolio are publicly listed and trade every day. It is estimated that around 38% of the fund could be sold in one to three days.
The promise of strong long-term returns
BRFI has a market cap of £255m and has decent secondary market liquidity with shares worth an average value of £350,000 traded daily over the last 12 months. The shares typically trade very close to their NAV, whereas many of the fund’s Emerging Markets peers are available at a discount.
The tight discount/premium is due to the fact that once every five years shareholders are given the option to realise their entire holding at NAV less costs. This is a valuable feature of the fund with the next opportunity expected to be at some point in 2021. The first time it was offered in February 2016 resulted in 4% of the issued shares being redeemed, with all of them successfully placed in the secondary market.
Another attractive feature are the dividends. These have increased every year since the fund was launched with the growth being driven by the strong underlying fundamentals of the investee companies. The fund is currently yielding 3.4% with distributions twice a year.
BlackRock charges an annual management fee of 1.1% per annum of gross assets and there is also a performance fee of 10% of any increase in the fund’s NAV above its MSCI Frontier Markets benchmark over the financial year. This is capped at 2.5% and is subject to a high watermark. The ongoing charge (excluding performance fees) of 1.4% is in line with the Global Emerging Markets sector.
Over the last 5 years the average net gearing has been a modest 3%, but the managers are extremely bullish at the moment and increased it at the start of 2017. It currently stands at 12% (20% gross).
Vecht and Fletcher believe that the Frontier Markets are reasonably cheap as they have not been significantly re-rated despite strong earnings growth in the last few years. The MSCI Frontier Markets index is currently trading on a PE ratio of 12 times earnings, whereas MSCI World and MSCI Emerging Markets are on 17 and 12.4 times respectively.
The BlackRock Frontiers Investment Trust has generated excellent performance since it was launched in December 2010 that is well ahead of its benchmark and wider peer group. It acts as a useful diversifying holding alongside more mainstream asset classes, with the ability to exit at NAV less costs every five years providing a valuable safeguard for long-term investors.