Frontier Markets Investing: Pros & Cons

Frontier markets is a relatively new term in the investing lexicon.  The term represents the smallest capital markets across the globe, those that are normally excluded from global capital indexes, unlike emerging markets, which are generally included.   Countries considered under the umbrella of frontier markets include Kuwait, Argentina, Nigeria, Romania and Pakistan, among over 30 constituent countries, representing a broad geographical mix.  The first index used to track them was established in the year 2000, and the first investable, liquid funds were available in 2008.  The track record on performance and risk is thus short compared to emerging and developed markets.

Should investors put their money into frontier markets?  This linked article (Frontier Equity Markets) provides an analysis of many of the variables to consider in this asset class.  We summarize with our own Pros & Cons lists here:

Frontier Markets

Pros	Cons
1) Low correlation within and across asset classes, improving diversification	1) Political risk
2) Low historical currency risk, as many frontier markets have their currency pegged to the U.S. dollar	2) High investment costs, both in local markets and via basket funds
3) Higher equity risk premium than other markets	3) Very low market capitalizations
4) High absolute returns and low risk historically relative to other equity classes	4) Low liquidity of underlying capital, leading to large cap index bias
5) Low relative valuations	5) Potential restrictions on capital flows and foreign ownership
6) Potential new countries, markets and frontier index expansion	6) Migration of countries from frontier to emerging indexes
7) Easily investible, with a number of basket products	7) Short track record of investment performance and risk factors
8) Economic freedom scores of constituent countries comparable to emerging markets	8) Lack of market regulation in some countries, which can lead to insider trading, market manipulation, etc.

On the Pros side, the diversification profile of the asset class, the historical risk/return relationship, and its investability stand out.  Historically, frontier markets have offered an attractive correlation profile to other major asset classes, one of the most important factors to consider for an investment in a portfolio context.  These metrics, however, have shown some erosion in recent years, although more data is needed to differentiate a paradigm shift from statistical noise.  In addition, the asset class has shown low cross-correlation within its own shell, meaning the constituent countries show low correlation to each other.  In short, the data show it has potential as an attractive diversifying asset class.  Further, the frontier markets showed the highest return with the least amount of risk compared to emerging and developed markets over the period from early 2000 through late 2012, with similar results in the nearly five years since that study.  That positions the asset class as a relative unicorn, as risk and return are normally correlated, with lower risk delivering lower returns.  Finally, there are sufficient investable products in the marketplace, with the largest mutual fund and ETF focusing on frontier markets both showing assets in excess of $600MM as of end July 2017.  

For Cons, the political risk, high investment costs and short track record are all important to consider.  Without a doubt, the largest concern is political risk.  Unlike domestic investing, and even most western capital markets (save for Brexit and Italy’s Tower of Pisa-like right leanings), frontier markets entail considerable political risk, where capital markets can be tossed into uncertainty or even turmoil by governmental actions both within and across its borders.   Consider the invasion of Kuwait by Iraq in 1990, the Argentinian nationalization of a controlling stake in oil and gas company YPF S.A. in 2012, or the impeachment of Dilma Rousseff in Brazil (although considered an emerging market) last year, and political risks become very apparent.  Second, investment costs are high, with some mutual funds charging in excess of a 2% expense ratio, and the available ETFs charging between .70 – .80%, high for that format.  Further, the ETFs can trade at discounts and premiums as high as 3.5%, an extreme range that seems to be exacerbated in volatile markets, exactly when investors want the ability to trade at net asset value.  Finally, given the short historical period to track this asset class, with the earliest index dating to 2000, it’s important to temper extrapolations and understand that the available time series of data is very limited.  

In summary, frontier markets for investors are very much like a bag of Skittles for kids: a rainbow of flavors, some of which you love, but others you might not like.  The asset class offers attractive return attributes as well as significant risk factors.  As we are big believers in an asset allocation meritocracy, irrespective of market capitalization, this asset class certainly deserves consideration, especially as a supplement for an international and/or emerging markets allocation.  However, it should be considered as a peripheral investment given the list of cons outlined above, and investors should fully understand the risks before investing.