The Final Frontier: Investing in Frontier Markets

At first glance it may not seem like a Kenyan brewer, a Pakistani cement manufacturer, and a Bangladeshi telecom venture have much in common. But all of these companies are publicly traded on stock exchanges located in so-called frontier markets — and international funds have invested in all of them.

What Is a Frontier Market?

The phrase frontier markets generally refers to developing markets that are smaller, with legal, financial accounting and regulatory infrastructure that may be weaker or less developed than emerging markets such as Brazil, Russia, India and China.

Notably, political stability and investor rights may be of greater concern in these countries. Often their securities markets are less developed, market depth and breadth may be more limited, and capital flows may be more restricted — all of which may present significant risks to investors. Frontier markets also may have less investor participation and fewer large global companies.

While not all index providers agree on which countries fit into the grouping, index providers MSCI, Inc. and the FTSE Group collectively give the frontier market title to 28 countries. Many countries on the combined list, such as Kenya and Bangladesh, have underdeveloped, fast-growing economies. However, the term also encompasses wealthier, resource-rich countries that have only recently loosened investment restrictions, such as Kuwait.

The group also includes small countries like Croatia and Baltic states such as Estonia and Lithuania, which lack the demographic clout of emerging markets, but still have fairly robust economies.

As of December 2014, 15 U.S.-listed frontier funds managed a combined $5 billion in assets, according to fund tracker Morningstar. However, the market capitalization of all the components that make up the MSCI Frontier Markets index, which tracks the performance of 24 frontier markets, is worth just $106 billion — some 3 percent of the $4 trillion MSCI Emerging Markets index, according to a December 2014 report by Morningstar. The amount of raw dollars in frontier funds is dwarfed by the $405 billion in assets in emerging market funds, the report said.

The Risks a Pioneer Faces

Frontier markets remain at the fringe of the investment universe because they are inherently risky propositions. Most are very young markets that can have fewer regulations than established markets. There also can be fewer opportunities to trade in and out of securities without impacting market prices, compared to more mature and more active markets.

The Nairobi Securities Exchange is a good example. The $23 billion market capitalization of all the companies listed on the exchange may sound impressive, but it has about the same market value as Twitter and it is tiny compared to the New York Stock Exchange, where listed companies have a combined market capitalization of $16.6 trillion.

In more mature economies, a stock market swoon may entice bargain-hunting investors to buy stocks while their prices are low. But the small investor base in frontier markets can make it more difficult to mitigate any decline. Hence, during the global financial crisis, frontier markets experienced the sharpest declines, with the MSCI Frontier Markets index dropping by 66 percent, compared to 58 percent for the MSCI Emerging Market Index and 49 percent for the MSCI USA Index.

Also, while frontier markets — as measured by the MSCI Frontier Markets Index — have outperformed emerging markets from 2012 to 2014, taking a longer view paints a less rosy picture. In six of the last 10 calendar years the MSCI Emerging Market Index outperformed frontier markets.

Growth in Frontier Markets

Many frontier markets have enjoyed solid economic growth in recent years, outpacing their counterparts in emerging and developed economies.

In 2013, Kenya's gross domestic product (GDP) grew by 5.7 percent and Kazakhstan grew 6 percent. Both rates are notably higher than Brazil, a large emerging market economy that grew just 2.5 percent last year. The contrast with some of the world's most advanced economies is even more pronounced. France's economy grew 0.3 percent last year, and even Germany, generally considered to be the economic engine of Europe, grew just 0.1 percent, according to the World Bank.

Frontier markets are growing fast because, in many cases, they're building a lot of new, critical infrastructure — buildings, roads and public transit systems. Those investments have a larger effect on a small economy than they would on a large one. Frontier markets also tend to have a younger, faster-growing population than more mature economies, which also tends to support higher GDP growth.

These high growth levels can certainly pay off. In 2014, the MSCI Frontier Markets Index increased more than 7 percent, while the MSCI Emerging Market Index actually fell some 2 percent.

It's important for investors attracted by high economic growth rates to remember, however, that frontier economies are starting from a low base. It's easier to generate 5 percent GDP growth in Kenya, which had a GDP of $55.2 billion in 2013 than in Germany, where GDP clocked in at $3.7 trillion the same year. But it may be much more difficult to sustain that kind of growth year to year in any individual country.

Aside from the perceived growth potential some people see in frontier markets, investors often see such funds as a means to diversify their portfolios. There are many ways to diversify — owning different asset classes, such as stocks and bonds, is one way. But investing in different parts of the world is another way, and frontier markets may fit the bill for some investors.

Things to Remember

Those taking their chances in faraway markets by purchasing an exchange-traded fund or mutual fund should find out exactly what the fund invests in — both the countries and particular companies — to assess the risks and prospects of the fund.

Many existing frontier market ETFs track indices, while frontier market mutual funds are actively managed. And the indices tracked by different ETFs can vary greatly in the regions and sectors they cover.

As always, it's important to understand the fees that a particular fund charges and what expertise the fund manager running it has in the developing world. You can compare different funds using the Fund Analyzer.

In the end, a globalized, interconnected world makes it easy to invest in out-of-the-way places. But investors must remember that developing economies often have more fragile political and financial systems, and may be prone to more turbulence than investors are accustomed to.