Frontier markets, and the mutual funds and the exchanged-traded funds that invest in them, are rapidly becoming a separate asset class, distinct from emerging markets. In 1992, the term frontier markets was coined by the International Finance Corp. to designate countries that have lower market capitalization and liquidity than more traditional, so-called emerging markets, which are more developed.
Frontier markets represent approximately 1 percent of the entire international equity universe. As of December 2011, MSCI Barra identified 25 countries as frontier markets. Approximately 30 percent of the total global population is spread across frontier nations, and some are among the world’s fastest-growing economies. These include Kuwait, Qatar, UAE, Nigeria, Kazakhstan, Pakistan, Argentina, Sri Lanka, Bulgaria, Croatia, Kenya and Oman. These nations have demonstrated a low relative correlation to traditional U.S. equity markets and, thus, over time, may constitute a positive element to broader portfolios seeking diversification and risk management.
The potential for rapid growth, as these countries seek to catch up with their more prosperous neighbors, makes frontier economies an attractive long-term investment opportunity. From June 2002 through December 2011, comparing the performance of frontier markets, emerging markets, non-U.S. developed markets and the U.S. markets, frontier markets were the second-best performer, with U.S. markets performing the worst during that time period. Furthermore, investments in frontier economies can help lift millions of people out of poverty. Some investors may therefore view frontier markets as an ethical investment.
There are many risks associated with investing in frontier markets. Compared with emerging and developed markets, their economies are not as integrated into the global economy. Frontier markets are subject to event risk, political risk and are exposed to commodity price movements. In these smaller frontier economies, liquidity, or the potential lack thereof, is also a risk. For stretches of time there may be no market for a stock of a frontier market company. The regulatory scheme within these countries varies and often provides far less oversight than in more developed countries.
On a more positive note, some economists believe that frontier markets are less influenced by global conditions, such as the current credit crunch. In addition, the overall correlation between frontier markets and developed markets has historically been lower than the correlation between emerging markets and developed markets. Since January 2008, the correlation between the MSCI Emerging Markets Index and the MSCI Developed Markets Index was 92 percent, compared with 78 percent for the Frontier Markets Index. In other words, an allocation to frontier markets would have offered some diversification benefit to an equity portfolio because of its lower correlation properties.
A small allocation to frontier markets can provide investors with multiple benefits. The primary benefit is access to economies in the early stages of development, and thus the potential for significant growth. A prudent approach to investing in frontier markets would be to allocate a portion of your at-risk capital to this asset class. As with any well-contemplated asset allocation strategy, avoiding too much exposure to any asset class is paramount. Over the last two years, access to frontier markets has gotten easier through the introduction of numerous mutual and exchange-traded funds. An investor should do extra homework prior to committing capital to a relatively new asset class. We recommend that investors research the fund’s management team. For example, are they experienced in investing in this space? We also recommend reviewing the parent company for the same reason. Some, but not all, mutual fund shops have an established reputation in international investing.
As discussed earlier, there are many risks to investing in frontier markets. An investor needs to weigh these risks versus the potential benefits to determine if investing in frontier markets fits into his or her long-term financial plan. •
David Pilaitis is a director and chief compliance officer with Citrin Cooperman Wealth Management. He provides comprehensive financial planning and investment advisory services to the firm’s clients, including high-net-worth individuals, corporate executives, trusts and small pension plans. He can be reached at 215-545-4800 or firstname.lastname@example.org.
Daniel J. DeSimone is a director with Citrin Cooperman. He specializes in providing comprehensive portfolio and wealth management, tax and estate planning services for high-net-worth individuals, families and trusts. He can be reached at 203-847-4068 or email@example.com.