THE FINAL FRONTIER INVESTING IN FRONTIER MARKETS EQUITY JUNE 2013

TABLE OF CONTENTS INTRODUCTION .................................................................................................................................................................................1

WHAT QUALIFIES AS A FRONTIER MARKET?...............................................................................................................................2

INVESTMENT THESIS........................................................................................................................................................................4

RISK AND RETURN CHARACTERISTICS........................................................................................................................................6

KEY FEATURES AND RISKS...........................................................................................................................................................10

IMPLEMENTATION...........................................................................................................................................................................12

CONCLUSIONS.................................................................................................................................................................................14

APPENDIX A......................................................................................................................................................................................16

MERCER 1

INTRODUCTION Over the last three decades, emerging markets have become an increasingly important part of the global economy and emerging market equities are now widely held as part of a broadly diversified equity portfolio. Representing less than 2% of the global equity universe 25 years ago, emerging markets now account for around 13% of the global equity market capitalization (based on MSCI index data). Early investors in emerging markets would have achieved a return of 12.7% p.a. (in US dollars) over the 25 years to December 31, 2012, outperforming developed markets by 5.5% p.a. Many investors are now asking whether frontier markets present investors today with a similar opportunity to that available to emerging markets investors in the 1980s. In this paper we address the following questions: How is the frontier markets universe defined? What is the investment case? What are the risk and return characteristics? What are the key features and risks? How should investors approach frontier market investment?

MERCER 2

WHAT QUALIFIES AS A FRONTIER MARKET? The term ‘frontier markets’ was coined by the International Finance Corporation (IFC) in the early 1990s and is typically used to describe smaller, less liquid and less developed markets than those contained within the developed and emerging market universes. There is no single definition for what constitutes a frontier market, with index providers and investment managers defining the universe in different ways. The main index providers typically include countries of the former Soviet Union, Africa, the Middle East and parts of Latin America and Asia. In constructing frontier market equity indices, providers in general apply criteria on market size, liquidity and accessibility. Many investment managers, however, define the frontier markets universe as everything falling outside the traditional developed and emerging markets indices.

The charts below show the MSCI Frontier Markets Index split by country and sector according to market capitalization, as at December 31, 2012. A list of the countries falling within each index provider’s definition of frontier markets as at December 2012 is provided in Appendix A.

MSCI Frontier Markets Index (December 31, 2012)

Source: Thomson Reuters Datastream

QATAR

KUWAIT

UAEJORDANOMAN

BAHRAINLEBANON

NIGERIA

KENYATUNISIA

MAURITIUSPAKISTAN

VIETNAM

BANGLADESH

SRI LANKA

KAZAKHSTAN

CROATIA ROMANIA

SLOVENIA SERBIAUKRAINE ESTONIA

LITHUANIA BULGARIAARGENTINA

MERCER 3

The MSCI Frontier Markets Index is highly concentrated in the Middle East and in particular in Kuwait, Qatar and the UAE (which together comprise c.50% of the index). In addition, the finance sector dominates the index and there are large single stock biases, with two Kuwaiti banks accounting for over 10% of the index as at December 31, 2012. Financials (and banks in particular) often dominate the listed equity markets of developing economies as they are typically among the first businesses to seek external financing. Over time, we would expect these markets to become more diverse by sector as an increasing breadth of business sectors emerge and look to raise equity capital. While many of the Middle Eastern countries have relatively underdeveloped financial markets, justifying their frontier market status, their economies are relatively developed by many measures, and their economic characteristics (such as per capita income) diverge significantly from most other frontier (and emerging) markets. For this reason, index providers also run frontier market indices excluding countries falling within the Gulf Cooperation Council (GCC)1.

MSCI Frontier Markets ex GCC Index (December 31, 2012)

Source: Thomson Reuters Datastream

This index is less concentrated by country and sector, with Nigeria the largest country at around a fifth of the index. Financials remain the most significant sector concentration at around a third of the index, with energy, materials, consumer staples and telecoms the next most significant sector exposures. 1 The Gulf Cooperation Council is a political and economic union of the Arab states bordering the Persian Gulf and located on or near the Arabian Peninsula, namely Bahrain, Kuwait, Oman, Qatar, Saudi Arabia, and United Arab Emirates. Jordan and Morocco have also been invited to join the council.

MERCER 4

INVESTMENT THESIS

Frontier markets account for a significant proportion of the world’s population, a small but growing proportion of global GDP, but a tiny proportion of global stock markets. The table below compares the developed, emerging and frontier markets (as defined by the MSCI indices) as at December 31, 2012.

Developed markets Emerging markets Frontier markets

Economic statistics

% of world GDP 61% 30% 4%

% of world exports 52% 33% 7%

% of world population 13% 56% 11%

Investment statistics

Market capitalisation $25,609bn $3,865bn $107bn

Market capitalisation (%) 86.6% 13.1% 0.4%

Number of securities 1,610 821 141

Average size of stock $18.3bn $9.6bn $2.8bn

Number of countries 24 21 25 Source: Index data from Thomson Reuters DataStream, World Bank, United Nations Population Survey, WEO, CIA World Fact Book. Market capitalisation is shown on a free-float basis.

While frontier markets are far from being a homogeneous group, many of these economies are in the early stages of development and have been some of the world’s fastest growing economies in recent years. Indeed, six of the ten fastest growing economies in the world over the last decade were in Africa2 and many of today’s frontier markets are expected to continue to experience strong GDP growth in the future. The chart below illustrates IMF growth projections for a selection of countries and regions (Nigeria and Kenya shown separately as the largest frontier markets in Africa).

* Middle East, North Africa, Afghanistan, and Pakistan. Source: IMF (average GDP growth forecasts on a constant price basis).

2 The Economist – The Hottest Frontier (6 April 2013).

0 1 2 3 4 5 6 7 8

Developing Asia

Nigeria

Kenya

MENAAP*

G7

IMF growth forecast 2014-2018 (%p.a.)

MERCER 5

Strong economic growth is helpful, but perhaps the most compelling argument for investing in frontier markets is their favourable population and demographic trends. In contrast to much of the developed world, countries in Africa are expected to see a significant expansion in their working age population over time (The Economist notes that in three decades Africa is expected to have a larger working age population than China2). In 2005, Jim O’Neill3 identified the “Next 11” (the 11 largest countries4 by population after the BRICs) on the basis that these economies should benefit from their young and growing populations, rising incomes and strong GDP growth (driven by population growth and productivity improvements). Four of the Next 11 (Bangladesh, Nigeria, Pakistan, Vietnam) sit within the frontier markets universe (the others, with the exception of Iran, are part of the emerging markets universe). Frontier markets are in the very early stages of their economic development and are expected to experience strong population (and labour force) growth in the coming decades. Investment in these markets therefore offers exposure to a different driver of returns to that available from investment in developed (and to some extent emerging) markets. While there can be no guarantee that strong GDP growth and a growing labour force will translate into strong returns to equity investors, we believe that these features should, in general, be favourable for the corporate sector and create conditions that might be supportive to equity investing. We discuss the many and varied risks associated with frontier markets investing in next section.

3 Former Chairman of Goldman Sachs Asset Management and inventor of the term BRIC (standing for Brazil, Russia, India, China) 4 Bangladesh, Egypt, Indonesia, Iran, Korea, Mexico, Nigeria, Pakistan, Philippines, Turkey, Vietnam

MERCER 6

0

100

200

300

400

500

600

Cumulative index returns

MSCI The World MSCI Emerging Markets MSCI Frontier Markets

RISK AND RETURN CHARACTERISTICS

The chart below compares the performance of the MSCI World Index, the MSCI Emerging Markets Index and the MSCI Frontier Markets Index (all in US dollar terms) since December 31, 2002 (the earliest available date via Thomson Datastream) to December 31, 2012. The table below shows the annualized returns and volatility for each index over the full period (also in US dollar terms).

Past Performance (December 31, 2002 – December 31, 2012)

Region Returns

(% p.a.) Volatility (% p.a.)

Developed 8.1 16.2

Emerging 16.9 24.1

Frontier 8.4 21.0

Source: Thomson Reuters Datastream. Index returns are gross of transaction costs

The chart above shows that the MSCI Frontier Markets Index outperformed both the MSCI World Index and the MSCI Emerging Markets Index from December 31, 2002 to December 31, 2005. Emerging markets then strongly outperformed both the developed and frontier markets until the onset of the financial crisis in 2007. All three indices are below their peaks at December 31, 2012, but the MSCI Emerging Markets Index has experienced a significant rebound. Underperformance by the frontier markets since the financial crisis may be explained by the dominance of financial stocks in these markets, political instability in northern Africa and the Middle East, and investor preference for safe-haven assets.

The S&P frontier indices have a longer track record (going back to 1995). The chart on the next page shows performance for the S&P developed, emerging and frontier ex GCC indices to December 31, 2012 (all in US dollar terms). The table below shows the annualized returns and volatility for each index over the full period (also in US dollar terms).

MERCER 7

0

100

200

300

400

500

600

700

Cumulative Index Returns

S&P Developed BMI S&P Emerging BMI S&P Frontier ex-GCC BMI

Past Performance (December 31, 1995 – December 31, 2012)

Region Returns

(% p.a.) Volatility (% p.a.)

Developed 6.7 16.4

Emerging 8.8 24.9

Frontier ex GCC 7.8 15.7

Source: S&P and Thomson Reuters Datastream. Index returns are gross of transaction costs. Note: The index returns are gross of transactions costs which, as we show later, can be substantial, thereby reducing the returns to an index-tracking strategy.

This illustrates that the frontier ex GCC markets outperformed developed and emerging equity markets over the period from December 31, 1995 to the onset of the financial crisis in 2007 and remain ahead of developed markets (but behind emerging markets) over the full 17 year period. It is notable that the volatility figures for the frontier indices are lower than those for the emerging indices (and even lower than developed markets for the longer period). This is likely explained by the lower liquidity of these markets which feeds through into less frequently traded and, as a result, apparently less volatile markets. This reinforces the point that headline volatility numbers are not a full representation of risk. The chart on the next page, showing calendar year returns for developed, emerging and frontier markets, illustrates the magnitude of positive and negative returns that would have been achieved by investors in these markets over the last decade.

MERCER 8

Calendar Year Returns

The performance of the frontier markets index as a whole also masks the underlying volatility of individual country level performance. The table below shows the best and worst performing frontier markets in each of the last ten calendar years.

Best and Worst Performing Frontier Markets

Year Best performing Worst performing

2003 Kenya +236% Lebanon -4%

2004 Estonia +73% Kenya -12%

2005 Lebanon +120% Slovenia -15%

2006 Croatia +122% UAE -47%

2007 Mauritius +112% Sri Lanka -13%

2008 Tunisia -6% Ukraine -84%

2009 Sri Lanka +191% Bahrain -32%

2010 Argentina +77% Bahrain -18%

2011 Qatar +8% Ukraine -46%

2012 Nigeria +63% Ukraine -49%

Source: Thomson Reuters Datastream. Returns shown in US dollars.

The table above highlights the potential for extreme divergence in performance between individual frontier markets over any one year period. This illustrates the opportunities and risk associated with investing in

Source: Thomson Reuters Datastream

-80%

-60%

-40%

-20%

0%

20%

40%

60%

80%

2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

MSCI The World MSCI Emerging Markets MSCI Frontier Markets MSCI Frontier Markets ex GCC Index

MERCER 9

-1.0

-0.8

-0.6

-0.4

-0.2

0.0

0.2

0.4

0.6

0.8

1.0

Frontier and Emerging Frontier and Developed Developed and Emerging

frontier markets and supports the case for investing in an active and benchmark-unconstrained manner (discussed further in the implementation section). It has also been argued that frontier markets offer investors a diversifying return stream given their relatively low correlation with developed and emerging markets. However, as the chart below illustrates, frontier markets have become increasingly correlated with developed and emerging markets since the financial crisis (reflecting the wider picture of increased correlations between ‘risk assets’ over this period).

Rolling 12-month Correlations

Source: Thomson Reuters Datastream. Using MSCI indices and USD returns.

MERCER 10

KEY FEATURES AND RISKS

Frontier markets is a diverse group of countries facing many different economic, political and social challenges. However, if we exclude the Gulf states, most frontier markets are characterized by a relatively small banking sector, under-developed legal and economic frameworks, and varying degrees of political stability. We outline below what we believe to be the main areas of risk that investors should consider when investing in frontier markets, under three broad categories (economic, political, market). This is by no means an exhaustive list of risks, as each country will be affected by many different risk factors, some of which will be specific to their economy and some which are not possible to identify in advance. ECONOMIC RISKS Exposure to the global economy: Many frontier markets are in the early stages of economic development with its attendant risks. They may also rely, to varying degrees, on exports and are therefore vulnerable to any significant slowdown in global growth. Inflation: Economies in the early stages of development will often experience volatile and persistently high inflation (in some cases leading to hyperinflation). This is often driven by food and commodity prices that are typically traded in US dollars. Given the difficulty and expense in hedging currency risk in frontier and emerging markets, inflation may erode returns to developed world investors via currency weakness. POLITICAL RISKS Social unrest: There remain significant social tensions within many countries that fall within the frontier markets universe. It is therefore possible that social unrest or political upheaval could have a significant negative impact on local businesses and in turn on foreign investors – the occurrence of such events is highly unpredictable. Corruption: Many frontier (and emerging) economies are lacking in “soft” institutions (or these institutions may be nascent) and the application of contract law may be inconsistent. Corruption affects different countries to varying degrees, but could clearly have a negative impact on foreign investors who are likely to have far fewer protections than would be the case in developed markets. MARKET RISKS Capacity: Frontier markets are significantly smaller than developed and emerging markets in terms of market capitalisation. As a consequence, frontier markets tend to be much less liquid than developed and emerging markets. Indicative trading costs5 typically range from around 250-450 basis points (bps) in sub-Saharan Africa; 50-150bps in frontier European and Middle Eastern markets; 50-220bps in frontier Asia and Latin America. By way of comparison, trading costs in developed and emerging markets are typically around 50bps and 75bps respectively. Given these costs, in general we have a preference for manager approaches that look to control the level of turnover, especially for those trading in less liquid areas of the market. Corporate governance: As is the case in many emerging markets, standards of corporate governance in frontier markets typically fall well below the standards associated with developed markets. In addition, custody of assets, record-keeping and registration may not be as sophisticated or robust as developed

5 Trading costs defined as bid-offer spread plus any brokerage fees, exchange fees and applicable taxes for a given market. Costs based on an order of $5 million in size. Source: First State Investments

MERCER 11

markets. While we would expect transparency and reporting standards to improve over time, this clearly reflects an area of risk for frontier market investors. Regulation: Regulatory frameworks are still in the early stages of development in many frontier markets. Moreover, in some countries there is little precedent for policing of investor fraud and insider trading. We note that many of the risks that apply to frontier markets today are similar to those facing emerging markets investors in the past. In some areas (for example, liquidity, corporate governance and regulation) we expect to see a gradual improvement in standards over time, however, other risks (particularly political and social unrest) are much more difficult (if not impossible) to forecast. We would expect to see investment managers giving serious consideration to these issues as part of the portfolio construction process and we will evaluate the importance of these issues to their process as part of our ESG6 rating. Assuming that investors are aware of the risks and are suitably compensated for them, we do not believe that any of the risks outlined above render frontier markets uninvestable. Indeed, the existence of significant risks that will put off many investors from even considering investment should create attractive opportunities for knowledgeable investors. We believe that the risks discussed and the concentration issues associated with frontier indices mean that frontier markets investing should not be seen as a naïve “beta” opportunity, with success requiring investment via high quality active managers adopting an unconstrained investment approach.

6 ESG refers to Environmental, Social and Corporate Governance issues.

MERCER 12

IMPLEMENTATION

We have a strong preference for investment in frontier markets to be implemented on an active basis. While investors may be able to engage a passive manager to track a frontier index, or make use of an exchange traded fund7 (ETF) to achieve an index-like exposure, we believe that the range of risks to which investors in frontier markets are exposed, together with the concentrations inherent in market cap-weighted frontier indices, creates a powerful argument for active management. Furthermore, we believe that the low level of analyst research coverage of stocks in the frontier universe should create attractive opportunities for skilled active managers. Given our concerns around the concentrations inherent in frontier market indices, we would also advocate an unconstrained active approach, to avoid creating any incentive for a manager to replicate the characteristics of a given index. As an aside, while our focus in this paper has been on a listed equity exposure to frontier markets, we note that there may also be a case for accessing frontier markets via other asset classes, in particular, via private equity or infrastructure investment. However, the range of institutional-ready implementation options in these asset classes is relatively limited at present. Mercer has undertaken research on several strategies in the frontier markets space. The initial focus has been on strategies that are managed by teams that have a long history of investing in emerging markets, and have researched frontier market names in the past within their wider remit. Many of these managers have recognized the exciting growth prospects in the region and already have a good understanding of the opportunities available and how best to capture them. We are also familiar with a number of frontier market strategies that have not been formally rated – some of these are specialists operating with specific regional mandates e.g., Sub-Saharan Africa ex South Africa. One of the attractions of this asset class is that unlike developed and traditional emerging markets, where investors are faced with trade-off decisions between value, growth and quality characteristics, frontier markets offer opportunities to own good quality businesses with strong growth potential, that are attractively valued with high dividend yields. African mobile operators are a good example of stocks that our highly rated frontier markets strategies have exposure to. In developed markets, telecoms stocks are typically associated high dividend yields that come at the expense of low (and sometimes negative) growth prospects and highly geared balance sheets. Their African counterparts also provide high dividend yields, but offer more conservatively financed balance sheets as well as significant exposure to the growth potential of the African mobile user. Travelling to meet with company management and visits to sites (such as plants and factories) ‘off the beaten track’ are an essential input in the investment decision-making process for our highly rated frontier markets strategies. One manager in this region has spent several years in Nairobi, having identified this as an expanding economy with opportunities for growth in consumer spending. They may even look to open a regional office in Nairobi to make visiting more remote parts of the continent more accessible for the team. Consistent with our view that countries and companies exposed to the growth of the emerging domestic consumer offer attractive opportunities for investors, we have a preference for strategies that limit exposure to the Middle East. Many of these countries have developing financial markets, but are relatively developed economies. This is reflected in the highly rated frontier markets strategies we have at present, which are managed by genuine long-term investors who limit exposure to the GCC region. It is worth highlighting that a diverse range of approaches are used by managers in the frontier markets space, with each seemingly defining their investment universe (and benchmark for performance measurement purposes) in a different manner. Frontier markets is an area in which Mercer continues to undertake research. We expect coverage will grow as investor attention increases, liquidity improves and these markets evolve. The emphasis of future 7 Prominent examples include an ETF that tracks the MSCI Frontier 100 Index provided by iShares, and an ETF that tracks the S&P Select Frontier Index provided by Deutsche Bank.

MERCER 13

research will be on strategies that are primarily seeking to gain exposure to the growth potential of the domestic emerging consumers in this region. However, we would be happy to discuss variations on this theme with investors that are considering making an allocation to this asset class. We also note that some global emerging markets strategies will be willing to move into frontier markets when the manager believes they can find value in this universe. In addition, some strategies will look to access frontier markets exposure via companies listed on emerging or developed market exchanges. While these approaches may offer some degree of exposure to frontier markets, they will not capture the full opportunity set. However, for most investors this may represent the most pragmatic approach for gaining exposure to the asset class. Frontier market equity strategies typically have relatively low levels of capacity and will often have ‘lock-up’ periods reflecting the size and liquidity of these markets. We find that managers tend to have capacity limits of around $400m-$500m, although strategies that can also invest in the larger more liquid stocks in the Middle East will typically have a higher capacity limit of around $1bn. The size of assets that a manager would be willing to take on over a 12 month period might be somewhere around $75m-$300m, with investment typically via a commingled vehicle. Finally, fees for frontier markets strategies tend to be roughly double the typical fees for developed market equity strategies and around 50% higher than for a typical global emerging markets strategy (although clearly this will vary from manager to manager).

MERCER 14

CONCLUSIONS

Frontier markets are a diverse collection of countries in the early stages of their economic development. Many frontier markets are experiencing strong GDP growth and are expected to experience a significant growth in their working age populations over the coming decades. In particular, we believe that sub-Saharan Africa and parts of emerging Asia are well-placed to benefit from these dynamics. Given the capacity constraints and variable liquidity in these markets, it will be impossible for investors to move en masse into frontier markets. However, for investors with a significant governance budget and an already well-developed equity portfolio, we believe that a frontier markets exposure might offer an interesting complement to a broad emerging markets allocation, with the potential for long-term return enhancement. Investors should note that frontier markets are exposed to a range of risks common to developing economies, with political risk perhaps being the most obvious but least predictable. A well-diversified and actively managed portfolio (built with little or no reference to a market cap benchmark) should help mitigate these risks to some extent. In addition, we believe that the low level of institutional research coverage should create fertile ground for skilful investors – indeed, the alpha opportunity in these markets may be just as interesting as the beta opportunity. In terms of implementing an allocation to frontier markets, investors might consider giving an existing emerging markets manager the flexibility to invest ‘off-benchmark’ in frontier markets on an opportunistic basis (assuming they have the capability to manage such an allocation). However, ‘high governance’ investors looking to introduce a more meaningful exposure to frontier markets could consider specialist managers. We look forward to discussing this paper with you.

MERCER 15

Important Notices References to Mercer shall be construed to include Mercer LLC and/or its associated companies. © 2013 Mercer LLC. All rights reserved. This contains confidential and proprietary information of Mercer and is intended for the exclusive use of the parties to whom it was provided by Mercer. Its content may not be modified, sold or otherwise provided, in whole or in part, to any other person or entity, without Mercer’s prior written permission. The findings, ratings and/or opinions expressed herein are the intellectual property of Mercer and are subject to change without notice. They are not intended to convey any guarantees as to the future performance of the investment products, asset classes or capital markets discussed. Past performance does not guarantee future results. Mercer’s ratings do not constitute individualized investment advice. Information contained herein has been obtained from a range of third party sources. While the information is believed to be reliable, Mercer has not sought to verify it independently. As such, Mercer makes no representations or warranties as to the accuracy of the information presented and takes no responsibility or liability (including for indirect, consequential or incidental damages), for any error, omission or inaccuracy in the data supplied by any third party. This does not constitute an offer or a solicitation of an offer to buy or sell securities, commodities and/or any other financial instruments or products or constitute a solicitation on behalf of any of the investment managers, their affiliates, products or strategies that Mercer may evaluate or recommend. For the most recent approved ratings of an investment strategy, and a fuller explanation of their meanings, contact your Mercer representative. For Mercer’s conflict of interest disclosures, contact your Mercer representative or see www.mercer.com/conflictsofinterest. Mercer June 2013

MERCER 16

APPENDIX A Country constituents as at December 31, 2012

Country MSCI1 S&P Russell FTSE2

Argentina

Bahrain

Bangladesh

Botswana X

Bulgaria

Cote D’Ivoire X X

Croatia

Cyprus X

Ecuador X X X Estonia

Gabon X X X Ghana X

Jamaica X X Jordan

Kazakhstan X Kenya

Kuwait X Latvia X X X Lebanon X X Lithuania

Macedonia X X

Malta X X X Mauritius

Namibia X X Nigeria

Oman

Pakistan X Panama X X X Papua New Guinea X X X Qatar

Romania

Serbia X

Slovak Republic X

Slovenia

Sri Lanka

Tanzania X X X Trinidad and Tobago X X Tunisia

UAE X X Ukraine X Vietnam

Zambia X X

Totals 25 36 36 26 Source: S&P, Russell, Thomson Reuters Datastream, www.ftse.com 1MSCI cover Botswana, Ghana, Jamaica, and Trinidad and Tobago with standalone indices, but these fall outside their Developed / Emerging / Frontier classification. 2FTSE considers these markets Frontier, however, only 17 of them are represented in the FTSE Frontier 50 Index.