Even though emerging markets may stabilize after the current round of panic subsides, they may not regain their past glory any time soon. As major emerging economies are beginning to mature and slow-down, they will no longer able to repeat their stellar performance seen not that long ago.
Investors looking for the “next big thing” in the investing world are now turning to “frontier” or “pre-emerging” markets. These countries offer compelling investment opportunities with solid growth potential and low valuations.
The MSCI frontier markets index surged about 26% last year while the emerging markets index plunged more than 3%. The outperformance continues this year as well.(Read: 3 Top Ranked ETFs that will crush the market in 2014)
What are Frontier Markets?
Although there is no strict definition for frontier markets, these are typically countries that are in the earlier stages of economic development. Their capital markets are underdeveloped and not fully/easily accessible to foreign investors.
The term “Frontier Markets” was first used by the International Finance Corporation to describe a set of small, illiquid and underdeveloped markets. Now MSCI, S&P and Russell have their own definitions of “Frontier Markets”.
MSCI Frontier Markets Index currently includes 34 countries. Most of these countries are in Middle East, sub-Saharan Africa, Southeast Asia, Latin America or Eastern Europe regions.
Why Frontier Markets?
Frontier markets are expected to grow faster than emerging and developed economies. Further, they have relatively lower valuations as well as higher income yield.
As emerging markets have become increasingly integrated with the global markets, their correlations with the developed markets have increased and the benefits of diversification have declined.
On the other hand, frontier markets still have relatively lower correlations with the developed markets. Further, most of them were not did not see major foreign investment inflows in the past few years and thus are less vulnerable to QE taper. Thus adding them as small satellite holdings in an investment portfolio can improve risk-adjusted returns over long term.
Currency Factor in Performance
One of the reasons for outperformance of frontier markets is the currency factor. Some of the frontier markets—which saw strong performance in 2013 as well as this year—peg their currencies to the US dollar or to a basket dominated by the US dollar.
As such these currencies have remained steady while currencies of most emerging markets have suffered a lot of pain. Currency losses have been a big factor is emerging markets’ poor performance.
What are the Risks?
Before considering frontier market investments, investors need to be aware of liquidity and political risks of investing in these countries as they are much riskier even compared with most emerging markets. But risk-tolerant investors are likely to reap significant rewards in the long-term.
Below we have highlighted some of the options available to investors in this space.