Blog

In today’s investing world where many established markets have been lurching into loss in lockstep, investors are hungry for other options. They want new opportunities to match the mouthwatering performances of emerging markets such as Brazil and China in years gone by, and are prepared to accept higher risk for them. For healthy diversification of their portfolio, they also want these other investments to be low in correlation with the rest of the market – to increase their chances of being up even if the others are down.

Enter the frontier market. The IFC (International Finance Corporation, part of the World Bank) coined the term over ten years ago. It refers to a country that is less developed, but with good prospects for growth, thanks to economic and political stability, and a large enough population. In the life cycle of markets, what starts and survives as a frontier market can then turn into an emerging market like Ghana has become, and afterwards a developed market such as South Korea.

Today, Indonesia and Vietnam typify frontier markets with potential. With a population of some 238 million, Indonesia has a well capitalized banking system and relatively high consumer purchasing. Vietnam with 89 million people scores highly in manufacturing capability yet with an inexpensive workforce and highly affordable real estate, attracting business people from Singapore who have invested significantly in building factories there.

530 billion dollars (US) was the level of investment in the private sector of frontier markets in 2007, according to IFC estimates. Of that, six billion dollars came from the IFC itself, keen to demonstrate its faith in the viability of such markets and attributing its success at the time to its careful selection of the right projects to invest in.

Tracking performance is possible in several ways. The IFC offers global coverage with its Frontier Markets Index series. Standard and Poor’s focuses on its Select Frontier Index based on 40 of the “largest and most liquid stocks from countries that have smaller economies or less developed capital markets than traditional emerging markets.” The MSCI Emerging Markets index includes such diverse countries as Argentina (coincidentally a G20 member country), Romania, Kenya and Kazakhstan. Comparison of data such as the rate of growth of the GDP (gross domestic product) of countries in frontier, emerging and developed markets, as in the diagram below, also helps to assess the overall opportunity. Frontier markets have already made their way into various funds, such as the Caravel Fund and the “Next 11” from Castelstone , based on the term coined by Goldman Sachs in 2005 to identify the countries with Brick-like growth which offer lower price tags. The eleven are: South Korea, Mexico, Turkey, Indonesia, Vietnam, the Philippines, Egypt, Nigeria, Bangladesh and volatile states Pakistan and Iran.

Some of the larger financial institutions such as HSBC with its GIF Middle East and North Africa Fund are also looking to frontier countries for the next wave of growth. HSBC/Halbis fund manager Andrea Nannini says “Many of these countries are positioned to benefit from high and sustained commodity prices” and cites the infrastructure development programs that are happening as making these countries worthy of attention.

Which ones are likely to become the new stars is still a matter of debate. But even though there is no broad consensus on which group of countries to invest in, many investors have identified the “next Brazil” to be Nigeria. The substantial base of natural resources and the large population justify this point of view, according to Adam J.Kutas of the Fidelity Emerging Europe, Middle East and Africa fund, who points to the large population and substantial base of natural resources. Nigeria stands to gain from its large reserves of oil, rising commodity prices and contained inflation, while trade has been liberalized and the increasingly democratic political situation stabilized.

Similarly, other resource-rich economies in Africa also attract investment, with the trading of commodity futures becoming increasingly popular in the different funds concerned. However, frontier markets exist around the globe. Kazakhstan as the largest of the former Soviet republics has a booming economy with extensive reserves of minerals, metals and fossil fuels. Other ex-Russian breakaways may turn into investment opportunities for similar reasons in the future, once the political situation has settled down.

Yet for all the opportunities on offer, patience as well as an appetite for risk is still needed for any investor wanting to go this route:

Liquidity affects many frontier markets. Investors may not be able to cash in assets easily.

The equity market is frequently small in size: frontier markets can be significantly impacted by small movements in funds that result in major price fluctuations in that market.

Frontier markets often go hand in hand with evolving government structures and legal systems, where the goalposts are changing and manipulation of the market still remains a real possibility. This also makes frontier markets more volatile than their emerging or developed market counterparts.

Frontier markets are subject to more unknowns and greater variability. By definition, the market is in its infancy, without the body of knowledge that exists in other more mature markets. This makes it that much more difficult to predict future events and trends.

Furthermore, the low correlation with other more established markets does not mean that frontier markets will be unflaggingly profitable. They bring value to an investment portfolio in their ability to diversify an investor’s holdings and give some protection against swings in other sectors, but they can go up and down like any other market.

How much should you invest in frontier markets? Once again, opinions vary. For long term investment in the context of an already diversified portfolio and reasonable risk tolerance, some fund managers estimate between 2% and 5%. Other financial experts suggest you can still build an investment plan that has good chances of generating fair profits, but without relying on frontier markets or funds. They also point out that frontier market funds often have higher costs to investors, and that therefore such funds will have to perform that much better if the investor is to make a net profit.

Whatever your choice, frontier markets need careful examination before any move, both in terms of their intrinsic performance and potential, and in terms of your own situation and tolerance of risk. A frontier market may depend on demand for a limited range of commodities, which makes it vulnerable to changes in those specific markets. Both greater gains and greater losses are possible compared to development and even emerging markets.

Trevor Keidan wrote this post.

Trevor is Infinity's Managing Director and Chief Executive and resides in Hong Kong.

View Trevor Keidan's profile page.