What Are Frontier Markets and Why Invest in Them?

(Bloomberg) -- If emerging markets are the wild child of the investment family, offering potentially higher rewards in return for greater risk, then what about their smaller sibling, frontier markets? These include countries such as Sri Lanka, Kazakhstan and Nigeria where stock exchanges and currency markets are too small or underdeveloped to be classified as emerging markets. While frontier markets may bring investors more exotic thrills, and spills, they also somewhat counterintuitively can be a safe haven when markets are rocky.

1. What are frontier markets?

In the investing hierarchy, they are the bottom rung of three. At the top are developed markets (such as the U.S. and U.K.), in the middle are emerging markets (such as China and Russia). The denomination is not so much a judgment on a country’s wealth or stage of development as about its markets. Depending on who’s doing the classifying, there are around 30 frontier markets, mostly in the Middle East, South Asia, Africa and Eastern Europe.

2. How are they determined?

According to MSCI Inc., the world’s biggest index compiler, frontier markets need to meet subjective criteria, including “at least some” openness to foreign ownership and “at least partial” ease of capital flows. Objective requirements include at least two companies worth about $800 million each.

3. How are they different from emerging markets?

Everything’s on a smaller scale. Frontier markets have a combined market value of $715 billion; emerging-market stocks are worth $20 trillion. Trading volumes are relatively minuscule as are the number of listed companies; while Vietnam has more than 1,500, Burkina Faso counts just three and Benin one. Foreign participation tends to be much lower than in emerging markets and there are tighter restrictions on who can own shares.

4. Who invests in them and why?

Mainly local and state investors. Among the overseas crowd, it’s mostly active funds that get involved. Passive investments such as exchange-traded funds make up just 10% of estimated foreign flows. One of the main investor attractions is getting into a market before the crowds arrive. That can lead to outsized growth as an economy prospers and financial infrastructure develops. Pakistan’s main stock index grew at an annual clip of more than 25% in U.S. dollar terms in the eight years through end-2016, shortly before it got promoted to an emerging market.

5. How have they performed?

Some markets have rewarded long-term investors handsomely. Vietnam’s benchmark index rose by an annual average 9.8% in the decade through 2018 in local-currency terms -- including a 48% jump in 2017 and a 27% drop in 2011. That underlines the idiosyncratic nature of frontier markets and their increased sensitivity to local affairs. Sri Lanka’s main stock index fell 10% as a political crisis in October was followed by deadly terrorist attacks in April. As a group, the picture has not been especially rosy. Frontier markets under-performed their emerging counterparts in the four most recent calendar years, but over the past year they have edged ahead.

6. Can they be safe havens?

They are less vulnerable to external shocks so can be a secure spot to sit out a surge in market turbulence. Frontier markets are less correlated with the rest of the world’s markets due to their limited financial links. They are also less correlated with one another due to their geographic diversity. So while individual frontier nations may experience high volatility, the poor correlation makes a basket of frontier stocks gyrate less. However, like emerging markets, they are likely to bare the brunt of any concerted global selloff; both asset classes lost about 50% of their value in 2008. Indeed, frontier markets are a risky asset class where investments can be locked up either because of a debt default, currency meltdown or capital controls. There’s also the risk of hyperinflation in some markets.

7. Is emerging-market status every frontier market’s dream?

Not necessarily. Being upgraded to an emerging market can attract heaps more foreign investment and boost a country’s efforts to open up its financial sector. On the other hand, frontier markets that were once a big fish in a small pond can become lost in the emerging-market ocean. Pakistan’s market, for example, failed to attract sizable investment flows after its elevation to an emerging market in 2017 and experienced the worst foreign selloff since the 2008 financial crisis.

8. Are frontier markets disappearing?

The frontier market class is shrinking, as more countries graduate to become emerging markets. In the past five years, some giants of the asset class have stepped up, including Qatar, the United Arab Emirates, Pakistan and, as of May 28, Argentina. Kuwait, which accounts for one quarter of the MSCI Frontier Markets Index, may also get promoted in June. These frontier heavyweights have been replaced by smaller territories that cannot make up the loss in market value. Although the frontier-market universe has lost some of its bulk, the smallest countries benefit as funds are forced to diversify their allocations.

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