IT IS the ultimate in risk versus return. Hunters of investment exotica are heading to Africa, where some of the world’s riskiest markets are now enjoying big gains.

After trailing behind more mainstream markets for the better part of a decade, frontier markets as defined by index provider MSCI have climbed more than 8% already this year — outpacing both emerging and developed stock markets.

Vietnam, Dubai, Argentina and Kazakhstan have all enjoyed a robust start to the year, but fund managers argue that the real frontier market stars are Africa’s bourses. "There is a second scramble for Africa under way," says Bank of America Merrill Lynch head of South African operations Richard Gush.

The larger sub-Saharan markets have been the primary beneficiaries. While some smaller markets, such as Namibia and Zambia have languished, Nigerian stocks have returned almost 63% in US dollar terms over the past 12 months, Kenya’s Nairobi all-share index has returned 46% and Ghana’s market has climbed more than 17%.

That is quite a turnaround. Before the global financial crisis, many frontier market investors mostly favoured countries such as Vietnam, and regions such as the oil-soaked Gulf. Nowadays, it is Africa that is the continent on investors’ lips, notes asset manager Silk Invest CE Zin Bekkali. "When the frontier markets story started before the crisis people actually tilted away from Africa, but these days that is where they want to go above all," he says.

Investing in the continent’s stock markets can be a turbulent ride, due to the underlying shares and the choppiness of exchange rates. For example, Namibia’s market is up about 8% over the past year, but down 10% in US dollar terms. The economic gains of many African countries are also linked to commodity export booms. Sceptics caution that if that unravels, growth — and investor prospects — will be dented.

The limited size and depth of the markets are also a challenge. Ashmore estimates that, excluding the South African market, there are about 250 investable companies across 17 exchanges worth about $250bn. But this makes the overall market smaller than Denmark’s, and about the same size as the Philippines’.

Trading volumes are woefully low by international standards. Even Nigeria’s stock exchange — the busiest in sub-Saharan Africa, apart from South Africa — only sees shares worth $40m a day on average change hands. Investors therefore face difficulty exiting larger investments. Even access can be a technical challenge in some markets.

Yet some fund managers are still attracted to African equities.

While the developed world faces years of economic torpor and painful de-leveraging, and some larger emerging markets are seeing growth slow, many African countries are enjoying an economic renaissance.

Asset managers argue African shares are cheap. Even after the recent run, most exchanges are only now trading at roughly the same or slightly lower forward-looking price-to-earnings ratios as emerging markets.

Ashmore fund manager Julie Dickson argues that the rally should be sustained by still-compelling dividend payments. She estimates that the dividend yield is about 6% on average in Africa, compared with about 3% in emerging markets.

African markets also offer some diversification away from the risk-on, risk-off forces that have dominated global markets.

Although smaller frontier markets can be highly volatile, they largely move for reasons independent of events in the US or Europe — an attractive characteristic for many fund managers, BlackRock chief investment strategist Russ Koesterich points out.

In fact, the main driver of African exchanges of late appears to have been big global and emerging equity funds taking "off-benchmark" positions in local companies — not necessarily inflows into dedicated frontier and Africa-focused funds.

These emerging market funds may only take small positions relative to the assets they control, but their size means their bets can have a big effect.

Nigerian Breweries, for example, boasts a list of shareholders that includes Franklin Templeton, Oppenheimer and Fidelity, via their emerging market funds. That has helped the company’s shares rally almost 80% in US dollar terms over the past year.

"There are definitely a lot of off-benchmark bets by global emerging market funds, which is a bigger story than dedicated frontier market funds," says State Street Global Advisors global chief investment officer Richard Lacaille.

Nonetheless, history has shown that the appetite for frontier markets such as those in Africa is fickle. If investors’ appetite for risk evaporates again, money could pour out quickly.

Financial Times