For many people, the word “frontier” conjures up images of rugged cowboys and settlers taming the Wild West as they expanded the borders of our country back in the 1800s. But frontier also has an investment connotation, describing a particular type of equity market and strategic asset class.
Frontier equity markets are the stocks of smaller nations at earlier stages of development — both economically and politically — than nations considered to be in emerging markets. Frontier markets usually have modest market capitalizations and a limited degree of liquidity. They are sometimes considered the “last frontier” of investing in today’s interlinked global economy.
The use of the term “frontier market” first arose in the early 1990s when it was used by International Finance Corporation to describe a particular subset of emerging markets. The first frontier market index was created by Standard & Poor’s in 2007, and there are now four major frontier market indices: the S&P Frontier BMI, the MSCI Frontier Markets Index, the Russell Frontier Index and the FTSE Frontier 50 Index.
Frontier markets are located mainly in the Middle East, Asia, Africa, South America and Eastern Europe. In determining whether a country should be categorized as a frontier or emerging market, indices typically consider the nation’s current stage of economic and political development, how accessible and liquid the market is, and any foreign investment restrictions, among other factors.
Classifying a country’s stocks as emerging or frontier is highly subjective, which can lead to inconsistencies in how different indices classify certain countries. Take Pakistan, for example: It is classified as an emerging market by the FTSE Frontier 50 Index, but as a frontier market by the other major frontier market indices. In addition, countries can be moved from the emerging to the frontier market classification or from frontier to emerging market. For example, Qatar and UAE were recently moved from the frontier to the emerging market indices.
Banking and financials tend to be the largest industry sector in most frontier markets, accounting for at least half of a frontier market’s index. Telecoms and industrials also usually make up a substantial portion of a frontier market’s index, while healthcare, consumer discretionaries, energy and utilities tend to be underweighted in these indices.
With some frontier market indices outperforming developed and emerging market indices so far this year, more investors have started to pay closer attention to frontier markets. Should you consider adding frontier markets as a strategic asset class to your investment portfolio?
In a recently published Market Perspectives paper entitled Investing on the Frontier, the authors make the case that investors should consider allocating at least a small portion of their portfolio to frontier markets. They cite three main reasons why:
- It can increase your diversification. One way to diversify your portfolio is to invest in different asset classes that have a low correlation with one another. This means that the stocks in these asset classes may move in opposite directions, which can further offset risk beyond mere diversification by asset. Emerging markets used to have a low correlation with developed markets, but this has started to change with the growth of large emerging markets like China and Brazil, whose stocks now generally move in the same direction as U.S. and European stocks.
- It can lower volatility in your portfolio. Historically, frontier markets have been less volatile on a relative basis than emerging markets. The authors of the paper attribute this to the fact that frontier market stocks are less correlated with each other when compared with the correlation between stocks of various emerging markets. This could make frontier market stocks appropriate even for conservative investors.
- Frontier market economies offer potential for fast growth. Due to their young, growing populations — the average age in frontier market countries is just 30 years old — frontier markets could be poised for faster growth than either developed or emerging markets in the coming decades. Most frontier market countries are also in the early stages of growing per capita income, so they can adopt technology from developed and emerging market countries to help accelerate growth.
However, frontier market stocks tend to be locally focused — for example, agricultural businesses and banks that are closely tied to their local economies. Therefore, these stocks usually have a low correlation with both developed and emerging market stocks.
Make no mistake, though: There are significant risks to investing in frontier markets. One of the biggest is geopolitical risk due to unstable governments in many of these countries. This instability can also lead to high (or even hyper-) inflation. There may also be a high degree of currency risk, though this risk is lower in countries like Qatar and UAE where the currency is tied to the U.S. dollar.
Frontier markets also usually offer limited liquidity due to their early stage of development and thin trading volumes. Moreover, a global downturn in the financial sector could hit frontier markets especially hard given the heavy concentration of banking and financial stocks that is typical in these markets.
In the end, you must weigh the risks vs. potential rewards of frontier markets to decide whether this is a wise investing strategy for you.