Ganna Reshetova, Postgraduate student in Finance

Taras Shevchenko National University of Kyiv

INVESTMENT OPPORTUNITIES IN FRONTIER MARKETS:

THE CASE OF UKRAINE

Scientific Advisor: Associate Professor Tetiana Hryshchenko, PhD

Under running integration processes, economic globalization and financialization, the frontier markets have become increasingly relevant in the world economy. Foreign direct investments have grown six-fold, mainly driven by intra-regional transactions. As the economies of these rapidly developing countries continue to open up to global investors, this trend is expected to further accelerate. As level of investments remains to rise, economies of frontier markets should continue increase their weight, not only in the global economy but also in terms of allocation to investors’ portfolios.

Frontier markets became the third generation of global equity exposure characterized by wide range of investment opportunities due to earlier stage of life-cycle development comparing to both developed and emerging markets.

Exposure to frontier markets increases the breadth and diversity of investing, over the capability provided by emerging markets enhancing total return potential driven by active growth and providing significant benefits from the traditional asset classes diversification. Specifically, frontier markets are quite small, but often lower priced than emerging markets, which themselves trade at a P/E discount to the developed economies.

Globalisation as well as financialization are creating real multidimensional growth in frontier markets – the emerging markets of tomorrow.

Fledgling frontier markets have a relatively low correlation with global peers, offer high growth potential and, currently, attractively low valuations relative to mainstream emerging counterparts. The very nature of the frontier markets means the earliest stage of financial system development in particular country, which is defined by low level of capitalization and liquidity along with limited access for overseas investors.

Due to foreign investor participation in developed and emerging markets, diversification benefits and some extent alpha potential have declined. Hence, money managers and sell-side strategists identify frontier markets as increasingly attractive area for equity investments.

The investment rationale is based on the following:

- High growth and return potential based on benefits from the structural development of these pre-emerging economies and market;

- Potential for high alpha, because of low sell-side research coverage in assessing these attractive early-stage investment opportunities and institutional ownerships within these markets segments are relatively low;

- Diversification benefits for clients and investors through asset allocation based on low return correlation with developed markets. Diversification allows spreading the risk across various asset classes and/or countries. Historically, frontier markets have been among the least correlated to other equity classes globally, making them attractive from an asset allocation point of view. Frontier equities have exhibited much lower correlations with global equities than mainstream emerging markets have. The additional diversification opportunity is low correlated with commodity indices.

Due to Broad Market Index for May 2012, Standard & Poor's classified Ukraine as a country with frontier market with adjusted market capitalization of 2.88 billion dollars [2]. Frontier markets (FMs) are investable but have lower market capitalization and liquidity than the more developed emerging markets. The frontier equity markets are typically pursued by investors seeking high, long term returns and low correlations with other markets. Figure 1 shows the evidence of great growth potential for Ukrainian economy relatively to emerging markets as well as developed ones. Comparing to developed economies of Germany, Japan, France etc., Ukrainian market shows great potential in future growth. On the other hand, the potential is not fully realized according to more than 6% GDP growth in emerging markets. It means that the cost of investing into economies of frontier market is much lower.

Figure 1. Expected GDP growth rate in 2010-2015 [3].

In spite of attractiveness of investing into frontier markets, systematic risks of such economies should be considered. Frontier market investments are typically perceived as being of higher risk than developed or emerging peers. This systematic risk could be divided into two groups:

Group 1. Sovereign risk:

- Political instability and limited democracy.

- Protectionism and capital control.

- Early stages of the financial system development.

- Dependence on natural resources provides greater risk in certain economic conditions.

Group 2. Structural risk:

- High volatility of returns and extreme price movements.

- Markets can have differing levels of accessibility for participant and/or investors.

- The costs of investing are high, trading infrastructure may be inadequate and transparency is low.

- Limited fiscal or monetary tools to handle increasing inflation.

The case of Ukraine shows the great impact of geopolitical decisions on economic situation in the country. Due to irrational basis of decision-making financial environment relies mostly on invers’ expectations. Creating the strong background for profitable investing, the cost of capital is underestimated by mentioned sovereign and structural risks.

As a result, considering investment opportunities, the key basic factors are important for overseas investor:

- Access to frontier markets not included in developed or emerging markets, largely untapped by institutional investors;

- Opportunity for early-stage investments in fast-growing economies;

- Low correlations with US and non-US developed equities;

- Locally driven economies result in low intra-market correlations among frontier market countries [4].

The implication of a country being labeled as frontier is that, over time, the market will become more liquid and exhibit similar risk and return characteristics as the larger, more liquid developed markets. The main advantage of investing in frontier markets is a great potential of fast transaction into developed economy.

References

1. Investing in Frontier Markets // HSBC Global Asset Management: https:// www.emfunds.us.assetmanagement.hsbc.com/investing-in-emerging-markets/content/investing-in-frontier-markets.fs

2. MSCI Frontier Markets Indices // http://www.msci.com

3. What are frontier markets? // Russell Investments, 2 Forum, March 2011: http://www.russell.com/AU/_pdfs/capital-markets-reserach/forum/2011-March -What-Are-Frontier-Markets.pdf.

4. Why invest in Frontier Markets now? // Silk Invest Report: http://www.silkinvest.com/why-invest-in-frontier-markets-now#sthash.bGak26 cH.dpuf