This year has seen the best start to the year for shares in developed economies in over 20 years. The US S&P 500 index has rallied 7.1%, the London based FTSE 100 has rallied 3.8%, the Australian based ASX 200 has rallied 4.1% and the Japanese Nikkei 225 index has rallied 9.4%. To put this into perspective the Sri Lankan market has fallen by 9.8%.
The eight worst performing share markets for the year have all been frontier markets such as Sri Lanka, Nigeria and Bangladesh. Frontier markets are now trading at their lowest valuations since 2008 versus the emerging market shares of countries such as Brazil, Russia, India and China.
Falling valuations reflect concern that growth in the smallest economies, which expanded about 20 % slower than larger developing nations on average during the past three years, won't accelerate in 2012. Many institutional fund managers are reducing their exposure to these frontier markets including Sri Lanka.
The price-to-reported earnings ratio for the frontier index, comprised companies with an average market value of $2.6 billion, dropped to 10.7 from 16 a year ago and trades at a 10 % discount to the emerging-market measure, made up of companies with a mean market capitalization of $12 billion.
"On a purely tactical basis, we have actually reduced exposure in frontier markets," Antoine van Agtmael, who oversees about $7.1 billion as chairman of Ashmore EMM in Arlington, Virginia told Bloomberg news.
"The larger, more liquid markets offered relatively more compelling investment opportunities."
Some of the reasons for institutional fund managers moving out of frontier markets is the perceived macroeconomic risk and liquidity risks associated with frontier markets. Frontier markets have smaller economies and worse rankings on gauges of business climate and corruption than emerging markets. They also have lower trading volumes, which make it more difficult for investors to sell shares.
Liquidity is one of the key issues with less than $15 million worth of shares traded on average on the Colombo Stock Exchange during the past month, compared with $12 billion on the Shanghai Stock Exchange in China, the biggest emerging market, according to data compiled by Bloomberg.
Other issues that fund managers perceive when investing in Sri Lanka are based on the increase in inflation and thus an increase in interest rates. This has been brought about by the government increasing petroleum prices this month and adding a fuel surcharge on electricity bills. Higher fuel costs and the rupee's devaluation to its lowest level since April 2009 have stoked inflation and prompted the central bank to raise interest rates for the first time since 2007.
Arjuna Mahendran the Singapore-based head of Asia investment strategy at HSBC Private Bank, which oversees about $500 billion sums up the sentiment of fund managers in relation to investing in frontier markets like Sri Lanka. He told Bloomberg, "I wouldn’t buy them immediately, I will probably wait until the end of the year once the tightening is complete, Because they are small, they tend to be really volatile, a little bit of money can pump the market up very fast, and vice versa."
(The writer is CEO Ataraxia Capital Partners and could be reached at info@ataraxiacapitalpartners.com).
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