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Frontier Markets Begin to Emerge

But for investors, frontier-markets funds have short track records and carry unique risks.

Patricia Oey, 12/17/2014

This article is an excerpt from the Morningstar research paper Frontier Markets Begin To Emerge, which examines the case for investing in frontier markets, discusses the risks, and provides an overview of the mutual fund and ETF investment options.

Frontier markets represent a tiny segment of the global investment universe, but interest in the asset class has been growing, as investors search further afield for better growth opportunities and pursue new ways to diversify their portfolios.  

Frontier markets, by definition, are at the far edge of the investment universe and are generally not included in global equity indexes or even in many emerging-markets equity funds. This is because frontier capital markets are not easily accessible. These markets tend to have a small number of liquid securities and restrictions on foreign ownership. Investors mulling the merits of this investment frontier should take a closer look before jumping in: The underlying risks and performance drivers are quite different from those in emerging and developed equity markets.

Surveying the Frontier
The investment case for frontier markets sounds enticing. Countries such as Kuwait, Nigeria, and Pakistan are at an earlier stage of development relative to emerging-markets economies. Many frontier-markets economies are entering a period of mid- to high-single-digit growth, thanks to a very low economic base, favorable demographics, growth in infrastructure spending, and, in some cases, abundant natural resources. And relative to emerging markets, certain frontier countries will benefit from the rapid adoption and dissemination of “new economy” services such as mobile banking and mobile payments, which should contribute to growth in the medium term.

Index providers MSCI and FTSE distinguish frontier markets from emerging markets by capital market size, liquidity, and accessibility thresholds on foreign ownership. In other words, investability is the primary criteria for a country’s classification, with aggregate and per capita GDP figures playing more of a secondary role. Market-cap-weighted frontier-markets benchmarks from these index providers primarily contain stocks listed in Africa, the Middle East, former Soviet Republics (also known as Commonwealth of Independent States or CIS), and less-developed Asian countries such as Pakistan, Vietnam, and Bangladesh. While frontier markets in African and Asian countries tend to have very low per capita GDP figures, the oil-producing states in the Middle East (also known as the Gulf Corporation Council, or GCC countries) are relatively wealthy. The reason these resource-rich nations are considered frontier markets is because they have restrictive foreign ownership limits on their exchange-listed companies.

To be sure, frontier markets are risky. Investors face a myriad of issues, which include political instability, social unrest, corruption, disease, terrorism, underdeveloped financial systems and capital markets, and a fickle regulatory environment. These risks are similar in type to those in emerging markets, but their probability and potential magnitude are greater. During periods of extreme market stress, frontier markets’ relatively illiquid stock markets can suffer sharp declines in the face of heavy selling. During the 2008 global financial crisis, the MSCI Frontier Markets Index had the largest maximum drawdown relative to the MSCI Emerging Markets Index and the MSCI EAFE Index (an index comprising developed Asia and Europe equity markets). Recent declines in commodity prices may prompt selling pressure in frontier markets, as many countries in the Middle East and Africa are commodity exporters.

Patricia Oey is an ETF analyst at Morningstar.

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