Go active in frontier markets, says Watson Wyatt

Active management is the best approach to take to frontier-market investments and can also be useful in more advanced emerging markets, according to research* published by Watson Wyatt this week.

The lack of quality data available on frontier markets seems to reduce the effectiveness of quantitative investment strategies, says the consultancy. Moreover, that same lack of data means fundamentally driven managers can exploit inefficiencies and mitigate exposure to potential fraud.

In addition, many products benchmark to frontier market indices, which are inherently biased towards the Gulf States (such as the United Arab Emirates, Kuwait and Qatar), and do not offer many of the economic and demographic attractions of other markets.

As for more advanced emerging markets, broad-based passive investments in the most favourable economies may be the best starting point, says Watson Wyatt, but "a number of factors can prevent such an approach". For example, the legal framework may prohibit investments in certain asset classes or there could be prohibitive product fees and poor vehicle structures.

Still, the consultancy recommends initially looking at asset classes that are large and liquid, correlated to macro trends, and have relatively low transaction costs and manager fees -- in particular, equities, debt and currencies.

However, certain factors -- such as deficiencies in existing indices or the specific nature of the market -- may mean that an active approach is still preferable in certain asset classes.

For example, with regard to emerging-market debt indices, some form of active management is essential, given the limited number of issuers (which emphasises the need to manage security-specific risk), the bias of market cap indices towards structurally weak countries and the ongoing development of debt markets, which may present opportunities.

Clients should also have exposure to a long-term dynamic basket of emerging-market currencies, funded in a diverse basket of overvalued G4 currencies (yen, dollars, euro and sterling), says Watson Wyatt. Such a strategy provides direct long-term exposure to higher relative productivity growth in emerging countries and global rebalancing themes.

Managing currencies dynamically requires an assessment of the main medium-term fundamental drivers of exchange rates, says the research. "One of our favoured investment approaches buys (for the long-term) those emerging currencies with the most robust structural fundamentals (mainly Asian currencies)," it adds, "while actively managing nearer term macroeconomic risks."

Watson Wyatt also highlights the importance of governance when considering emerging-market investments. "Allocating to emerging-market equity, debt and currency strategies will vary in complexity depending on the implementation route, so investors should assess their governance levels very carefully before proceeding," says the report.

"Similarly, allocation to other alternative asset classes requires cautious consideration, given the added burden on governance and associated high fees," it adds.

For example, real estate is reasonably correlated with GDP growth, although markets are highly heterogeneous and some markets are relatively immature. As for hedge funds, given the availability of so many different strategies and the immaturity of the sector, a skilled fund of funds can offer a compelling trade-off between the extra fees involved, says the report.

* Emerging wealth: Capturing the long-term growth dynamics of the emerging markets.