Wide spreads, illiquidity add cost to frontier markets

Investors looking for alpha in frontier markets should expect to pay the price of wider spreads and longer execution times, according to new research.

Investors looking for alpha in frontier markets should expect to pay the price of wider spreads and longer execution times, according to new research.

Mark Buchanan, director in trading strategy at Credit Suisse, said a host of dynamics could make investment in frontier markets more expensive, such as wider bid-ask spreads, lack of liquidity and cumbersome physical procedures necessary to trade.

“Frontier markets are an attractive option for investors seeking growth opportunities. However, their investable universe lacks the capacity to absorb large-scale institutional investment,” he said. “A general lack of liquidity also means that trading is costly and slow, especially at times of high stress.”

Based on MSCI country classifications, Credit Suisse estimates the entire market capitalisation of frontier markets at around US$645 billion, but the investable universe is even smaller because many securities are ruled out due to minimum size thresholds, a lack of liquidity or foreign ownership limits. Total market cap is US$12,300 billion for emerging markets and US$30,700 billion for developed markets.

“Broad frontier benchmarks are dominated by the Middle East, financials and a handful of large caps,” said Buchanan. “Investors who decide to take the plunge should therefore proceed with caution and be prepared for a bumpy ride.”

Yet, according to a survey of institutional investors by Abu Dhabi-based asset manager Invest AD, 66% of those looking to invest in frontier markets see Africa as the biggest opportunity, while 44% consider frontier Asia (such as Vietnam and Mongolia) as a priority. Just 22% saw the Middle East as the greatest prospects and 17%, Central or Eastern Europe.

But variations in spreads can mean even the most compelling investment idea could be more expensive than portfolio managers realise. “Average spreads are twice as high in frontier markets than they are in emerging markets and seven times higher than in the developed world,” said Buchanan. “Investors should expect much higher trading costs in frontier markets, where even the largest stocks have amongst the widest bid-ask spreads.”

New research from Credit Suisse shows that median bid-ask spreads throughout frontier markets differ dramatically – from around 190 basis points (bps) in Sri Lanka, to approximately 10bps in Qatar. Buchanan explained tighter bid-ask spreads are usually reflective of a more open and competitive market. Often in countries with relatively advanced exchanges, such as Vietnam, Argentina and Qatar, bid-ask spreads are lower. However, tick sizes also impact on bid-ask spreads, and Buchanan warned traders to be aware of differences across the asset class spectrum.

Lack of liquidity and the time required to make a trade can also add to costs. Frontier markets are usually more illiquid and what liquidity there is can dry up when a crisis hits, such as the recent sovereign debt crisis in Dubai, which severely affected liquidity.

“[Even] in ‘normal’ market conditions, the time taken to invest a relatively modest amount of money can be considerable,” said Buchanan, providing the example of the time taken to invest US$10 million across the MSCI Frontier Markets index at 25% participation, based on recent 20-day average volumes. Buchanan explained that while around 80% of such a trade could be executed in the first half of the initial trading day, he estimated it would take another two-and-a-half days to complete the entire trade.