WTF Are Frontier Markets?
In the world of investing, countries are divided into three economic categories: developed markets (including the U.S., Japan, and the European Union), emerging markets (such as China, India, and Brazil), and, lastly and lowly, frontier markets (including Argentina, Jordan, and Vietnam).
The frontiers have promise. However, in order to grow and prosper, they need to overcome serious problems like systemic corruption, poor corporate governance, and a lack of natural resources, among many other challenges.
Frontier markets, poor yet ambitious, are a volatile lot. Smart investors exploit this heightened risk to achieve better-than-average returns. But frontier markets can go full-out crazy over a day or two thanks to government coups, natural disasters, or terrorist attacks, laying waste to any well-planned investment strategy.
How Many Nations Are Frontier Markets?
Morgan Stanley Capital International (MSCI) creates international indexes for investors. It’s the authority on what constitutes a frontier market.
The company’s MSCI Frontier Markets Index tracks the performance of 114 companies in 29 countries based on demographics, economic development, politics, and liquidity: Argentina, Bahrain, Bangladesh, Benin, Burkina Faso, Croatia, Estonia, Guinea-Bissau, Ivory Coast, Jordan, Kazakhstan, Kenya, Kuwait, Lebanon, Lithuania, Mali, Mauritius, Morocco, Niger, Nigeria, Oman, Romania, Senegal, Serbia, Slovenia, Sri Lanka, Togo, Tunisia, and Vietnam.
To enter this club, a nation must have (at minimum) a stock-market regulator and no restrictions of withdrawing investments (when events turn bad).
Many Frontier Markets Have One-Dimensional Economies
Not only do these nations suffer from immature economies and stock markets, low levels of income per capita, and limited investment opportunities, but many are also one-trick ponies.
For example, many frontier markets are in the Middle East, where their economies are heavily reliant on oil.
Others used to be part of the Soviet Union and are struggling to rebuild their economies. Yet others, such as Argentina (which was the fifth largest economy more than a century ago), have economies limited to just agriculture and mining.
Frontier vs. Emerging Markets: Is There a Difference?
Of course. Brazil, China, India, and Russia are considered emerging markets. Investors dubbed them the BRIC nations, as they sit heavily atop the emerging-market food chain.
BRIC gets the whole idea behind free markets and free trade. But for years they have been hobbled by excessive government control of their economies. Now they are breaking free (not so sure about Russia, which is the clear oddball of the bunch).
They’re rapidly industrializing and investing more in productive capacity and expanding their economies beyond primitive, singular industries like agriculture, energy, and mining. They also have thriving stock markets and rising incomes, and they spread the wealth to their citizens.
However, BRIC and other emerging markets remain unable to join the world of developed markets because most of their citizens have lower-than-average per capita income compared with those in developed markets. The World Bank, for example, defines developed countries like the U.S. as those whose citizens have a per capita income of more than $3,895.
Why Invest in Frontier Markets?
It’s all about the risk-reward trade-off. Frontier markets are clearly risky bets, but some member nations, when they get their acts together or experience a string of good luck, can be an investor’s best friend. We’re talking about poor countries that are scraping the bottom, which means they have great potential growth. What else do they have to lose?
Historically, frontier markets tend to produce higher economic growth rates on average than developed or emerging markets.
And they typically exhibit a low correlation (they zig when others zag) to other asset classes like the stocks of developed nations or even emerging markets.
Also, many aren’t hapless cases. In fact, most have hard-working and resourceful citizens whose pent-up energy and desire to live a better life is typically held back only by government corruption, graft, and ineptitude. Once those obstacles are dismissed or neutralized, their economies can begin to grow organically.
Economists call that spare capacity, which measures whether an economy (or industry) is underperforming its maximum sustainable level of production. For humans, that means not living up to your potential.
Good Morning, Vietnam
Take Vietnam, for example. The Southeast Asian country is one of the fastest growing economies, with a GDP of about 7 percent (2017). Investors who know Asia see similarities between Vietnam and the China of two decades ago when its masses of poor workers started to become less poor and started upping their consumption of goods and services.
But investors see opportunities beyond Vietnam. The Ivory Coast and Zambia are getting a close look as they improve their public finances and win international financing. Argentina and Pakistan are also on investors’ radars after years of being seen as corrupt economic blackholes despite their educated, robust cultures.
Risk, illiquidity, and volatility are the biggest concerns. In the U.S., we have layers of rules and regulations governing commerce, corporations, and stock markets. Some frontier markets don’t. And if they do, oversight is often weak and ineffective.
Many frontier-market corporations have poor corporate governance. They’re not transparent about their operations, financing, and management structure. Those are risky bets. It’s like flying blind.
Plus, these companies are in a weakened position should misfortune strike, such as an earthquake that destroys a factory or terrorists who blow up a shopping center. Many can’t recover because they don’t have money or access to loans — the liquidity to withstand losses so they can make a comeback.
The other concern is volatility, which is par for the course. Investors want steady-eddy returns with predictable ups and downs, not extreme rollercoaster-like returns. For example, look at the MSCI Frontier Markets Index. Last year, the index fell 16 percent, but it increased 32 percent in 2017. That’s volatility on steroids. Year-to-date, the index is up 12 percent in 2019.
How to Invest in Frontier Markets
The best way to invest is via exchange-traded funds (ETFs). There are three dedicated frontier markets ETFs available: Guggenheim Frontier Markets (FRN), Global X Next Emerging and Frontier (EMFM), and iShares MSCI Frontier 100 (FM). As ETFs go, their expense ratios are a bit pricey. Still, they give investors broad exposure, which should tamp down volatility concerns.
That said, investing in frontier markets is not for the inexperienced. But adding a small portion of these struggling yet hopeful countries to an investment portfolio makes a lot of sense. It is all about diversity (with a bit of risk), isn’t it?