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The Peril and Promise of Frontier Markets

Now that everyone owns Russia and China, what's next?

Gregg Wolper, 06/03/2010

Just more than three years ago, I wrote a Fund Spy column about frontier markets, a group then gaining recognition from the investing public. The idea was that just as Brazil and Korea were once considered obscure destinations that gradually moved into the mainstream--handsomely rewarding some savvy investors over time--countries such as Vietnam, Nigeria, and Egypt would form the next wave.

It is perhaps no coincidence that that column appeared in late April 2007. As it turned out, that was near the top of a more than four-year-long rally in global stocks, and conventional emerging markets had led the way with astounding gains. No doubt some people started thinking that the risks of emerging markets were overblown, so they might as well dive deeper. Others perhaps felt that after such a long rally in emerging markets, those stocks were getting too well known, so it was time to look for more attractive values elsewhere.

As the global financial infrastructure wobbled over the next couple of years, frontier markets received far less attention. But lately, interest has revived. Perhaps one reason is that the year-to-date returns for several such funds top the charts in the diversified emerging-markets category, as the bigger emerging markets have stumbled. Whether the renewed interest is a danger sign I'll leave to the reader to decide. Meanwhile, with three years lapsed since the last column, it's time to revisit the group.

Explaining the Frontier
Frontier markets--sometimes called pre-emerging markets--are countries considered one step behind emerging markets in stock market sophistication. The factors considered for such an evaluation include the number of companies listed, trading volume, regulatory structure, and how easy it is for outsiders to invest. Of course, no hard-and-fast line separates a frontier market from an emerging market, just as, on the other end of the spectrum, the line can get fuzzy between emerging and developed markets.

That said, there's general agreement on which countries belong in the frontier group. Besides those listed above--Vietnam, Nigeria, Egypt--there are others in the Middle East such as Qatar and Oman, many sub-Saharan markets such as Kenya and Ghana, and a few in Europe, including Croatia and Ukraine. Note that more-familiar destinations such as China, India, Russia, Brazil, and Mexico, along with Turkey and South Africa, are all considered emerging rather than frontier.

Pros and Cons
Enthusiasts hope that frontier markets will repeat the course taken by the most successful emerging markets. Shareholders in many emerging-markets funds, whether broadly diversified geographically or focused on a single country, could have reaped huge gains by holding them over a long period. (Those who sold during the periodic crashes or bought at the tops, though, would have received quite different results.) The possibility that the enthusiasts might be right about frontier markets shouldn't be dismissed casually. Although expecting Ghana or Morocco to be the next Brazil or China is a stretch, there are sound companies with strong managements and admirable growth prospects available in many less-traveled corners of the world. Some are available at much cheaper prices than similar companies from more-familiar markets.

However, the risks are considerable. Almost by definition, frontier markets aren't as liquid as emerging markets, much less developed ones, so trying to sell a large chunk of shares (or even a small chunk) during a downturn could be difficult or impossible. Lax regulation can cause other problems, as can shareholder cultures and legal environments that can be even dicier than those in emerging markets such as Russia or China.

The Options
Few broad-based emerging-markets stock funds put much money in frontier markets. (Bond funds are another story.) One that had done so, DWS Emerging Markets Equity SEKAX, dumped those holdings and returned to the straight and narrow upon the arrival of a new management team last year.

That said, investors who are determined to explore this realm do have a much broader menu to choose from than they did three years ago, because of the growth in dedicated frontier-markets funds. In fact, there are too many to list here. Several fairly new frontier-markets funds can be found in the Market Vectors ETFs from Van Eck, including portfolios devoted solely to Vietnam and the Persian Gulf region. One look there reveals an abundance of stocks that are rarely found in other funds' portfolios. But the risks are equally evident. For example, 46% of the Gulf States Index ETF MES is invested in one country--Kuwait--and 45% is in banks.

On the mutual fund side, some choices for dedicated exposure are Harding Loevner Frontier Emerging Markets HLFMX, Templeton Frontier Markets TFMAX, Forward Frontier Markets FRONX, and T. Rowe Price Africa & Middle East TRAMX. Beware: In addition to the risks involved, these funds also tend to be very expensive and have short track records.

It would be tempting to conclude these funds won't succeed over the long term. But ING Russia's LETRX 10-year annualized return of 21.5% (through May 26), which trounces the MSCI EAFE Index's 0.5% return over that period and the diversified emerging-markets category average of 9.9%, indicates that investing in a costly fund that targets a once-obscure market wracked with political risk could, in fact, pay off.

However, whether an investor should take the plunge into a frontier-markets fund, rather than simply relying on a well-constructed portfolio of proven, lower-cost funds with long-tenured managers, is another question. Needless to say, it takes not only hope, and in many cases a blind eye to expenses, to believe in the prospects for these funds, but to benefit you'd also need the fortitude to hang on during some scary headlines and nasty declines. Take note: Though it has that gaudy 10-year record, ING Russia has twice suffered calendar-year losses of more than 70%. At times like that, hanging in there is easier said than done. 

Gregg Wolper is a senior analyst with Morningstar.

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