So, you’re ready to be the hero, to discover that final frontier or stake your claim in the unknown territories of the wild west.
Slow down, cowboy — as my book Frontier Investor: How to Prosper in the Next Emerging Markets explains, there are a few challenges when it comes to actively managing investments in a frontier market.
Advice About Active Management
There are possible downsides to an active investment management plan in frontier markets—more work, higher fees, and greater risk.
It’s absolutely true that, if done correctly, active investing takes more work— research, analysis, decision making, and decision monitoring—than does passive investing. Active investing is a time-consuming and resource-intensive process.
The second disadvantage of active investing is that it is more expensive. Trading costs are higher because turnover is usually higher, and active investors often buy less-liquid securities with higher commissions or wider bid/ask spreads.
Active managers also charge higher management fees than passive managers, typically seventy basis points or more for mainstream emerging market portfolios and upwards of 1.25 percent for frontier portfolios. These higher fees handicap active managers’ performance every reporting period. But frontier market indices’ irrational construction make them relatively easy to beat by active managers over long periods of time despite the managers’ higher fees.
Active management can also involve higher risk. Actively managed portfolios typically hold fewer positions than passive portfolios, so they derive less benefit from diversification, and a poorly performing position in a more concentrated portfolio will have a greater negative impact on overall returns. There is also the risk that the manager may not know what he or she is doing; this risk can be mitigated by studying the manager’s track record and (more importantly) how it was achieved, and by making sure that the manager has skin in the game. Having a substantial chunk of your manager’s net worth invested alongside you is a great way to ensure your manager keeps his or her eye on the ball.
Still, despite the possible downsides, I firmly believe that active investing is the right approach to frontier markets.