High net worth private investors, with the capital and appetite for new ventures, are the most enthusiastic backers of frontier market funds, according to new research from Cerulli Associates.

High net worth private
investors, with the capital and appetite for new ventures, are the most
enthusiastic backers of frontier market funds, according to new research from
Cerulli Associates.

Frontier markets - broadly
defined as the “next generation” of emerging markets - represent about a
quarter of the world's population, just under 11 per cent of global GDP and 2
per cent of global market capitalization, the research firm said.

In the October Cerulli Edge - Global Report, the firm
highlights that, according to the IMF, 22 of the 25 fastest-growing economies
will be frontier countries in the next five years. 

“For sophisticated investors,
there is a strong attraction in being a pioneer, since early gains are often
the largest,” it said. “Leveraging their own global business and
family networks, private deals and funds are often put together in bespoke
structures. This is evident in the growing number of private equity funds, both
listed and unlisted, targeting frontier markets, particularly in Africa.”

Global institutional
investors, although not as excited,
are now dedicating between 1 and 3 per cent of their emerging markets allocation
to frontier holdings – a “steep” rise from five or even three years ago, said
Barbara Wall, a director at Cerulli.

Data

According to data from
Cerulli, assets under management held in frontier market funds in the US rose from
$1.6 billion in 2011 to $3.2 billion as of May 2013, while net new flows edged
up from $0.6 billion to $0.8 billion during this time.  

Such growth was even more
apparent in Europe, as AuM held in such funds
swelled from $9.3 billion in 2011 to $15.7 billion in May this year. The pace
of net new flows also quickened, having risen from $0.5 billion in 2011 to $2.9
billion as of May.

“Money tends to flow to
markets with better infrastructure and liquidity, and then to those with low
correlations to other asset classes,” said Yoon Ng, Cerulli associate director.

Ng added: “In Asia, that
means Sri Lanka and Pakistan, while Argentina
is the champion in Latin America. In Africa,
investors are hailing opportunities in Ghana,
Tanzania, and Kenya. And in
Europe, there is nascent investment activity in tiny states like Macedonia, Bosnia,
Belarus, and Armenia.”

Although frontier GDP rates have
been slower than in emerging markets, volatility has actually been less of an
issue. The main reason for this is because these economies have fewer links to
international markets and are thus less impacted by developments affecting
their emerging market peers.

Indeed, a growing number of
wealth management firms in the US
are turning their heads to frontier market investment prospects.

In November last year, for
example, Northern Trust launched a Diversified Frontier Markets Index to
provide endowments and foundations with exposure to frontier markets.

“The natural evolution for
traditional emerging market portfolios will be into the frontier markets,
driving demand for the larger, more liquid index positions,” Greg Behar, senior
investment strategist for global index management at Northern Trust, said at
the time.

Meanwhile, UK-based Insparo
Asset Management appointed Glenda Levin as head of marketing, charging her with
spearheading a marketing drive targeting international investors, but with a
particular focus on the US.

Challenges

Critics, according to Cerulli,
believe that frontier markets “remain a risky subset of an already risky asset
class.”

As Northern Trust pointed
out, risks are also magnified as frontier markets generally have smaller
economies or less developed capital markets than traditional emerging markets.
Other risks perceived by investors include political instability, inadequate
regulation, sub-standard financial reporting and currency fluctuations.

But the biggest challenges – “essentially
one of confidence” - centers around the need for frontier markets to create a
virtuous liquidity circle to capitalize on potential inflows, Cerulli said.

The attraction of low debt
levels, low stock valuations, diversification and financial infrastructure will
wane if investors sense a lack of liquidity, it warned.