The Lure of the Frontier

Here’s an emerging market with some impressive numbers: Argentina’s stocks had an inflation-adjusted average annual return of 10.9 percent in a decade when equities in the United States averaged 7.1 percent and, in the United Kingdom, a mere 1.8 percent. And the following decade, Argentina continued to outperform, with a 4.5 percent annual gain, while U.S. and U.K. stocks dropped annually by 2.5 percent and 1.4 percent, respectively.

Chances are, though, that your clients didn’t benefit from these differentials. The two decades in question were 1900-1910 and 1910-1920 (calculated from January 1 to January 1 and compiled in the 2003 book A New Economic History of Argentina).

“Emerging markets” have been a major focus of the investment industry’s attention for the past two decades, and more recently, that attention has been supplemented by a growing interest in “frontier markets.” The latter term is taken to mean markets that are less well-developed than traditional emerging markets, in terms of size, liquidity and accessibility.

Back in 1952, French sociologist Alfred Sauvy coined the term “third world” for those countries that were not part of the developed “first world” or the Communist “second world.” In the early 1980s, Antoine van Agtmael, a Dutch banker then at the International Finance Corporation, began touting “emerging markets,” after finding that investors balked at the “third world” label. (It didn’t help that his proposed Third World Equity Fund came to be known as Third World Investment Trust — or TWIT.)

The term “frontier markets” is generally regarded as having originated in the mid-1990s when Standard & Poor’s began using it as a label in its index calculations. It’s become more widely used than alternatives such as “pioneer markets” and the unwieldy “emerging emerging markets.”

The categories of emerging markets and frontier markets have some fuzziness around the edges. Where exactly the boundary lies between frontier and emerging depends on the precise definitions used, as do questions of when a market is no longer emerging but rather developed, and whether frontier status itself requires meeting a certain threshold of openness to foreign investors.

Geographically, this frontier tends to be found in Eastern Europe, South Asia, the Middle East and sub-Saharan Africa. Nations widely regarded as frontier markets include Romania, Bulgaria, Sri Lanka, Vietnam, Kenya, Nigeria, Bahrain and Qatar. Lately, new indexes have been developed to monitor frontier markets, and exchange-traded funds have begun specializing in the new asset class. (See sidebar, “Tracking the Frontier.”)

Repeating the Past?

A great deal of interest in frontier markets has been driven by expectations that they will replicate the largely upward trajectory of many emerging markets over the past two decades. Coupled with such hopes are concerns that as traditional emerging markets move toward or into the developed category, they will no longer have the growth prospects of yore.

Enthusiasm for frontier markets also owes much to the broad surge in commodity prices of recent years, as many frontier-market countries derive a significant portion of their revenues from commodity exports. That raises the question of whether the frontier might become notably less attractive in an environment of weaker commodity prices.

Moreover, emerging markets with strong performance have often benefited from economic reform and not just upswings in commodity prices. A broad trend toward economic reform existed, however unevenly, in emerging markets over the past two decades. Worryingly, such a reformist trend is harder to discern in frontier markets today. Then again, some frontier markets, notably Persian Gulf oil exporters, have amassed much greater wealth per capita than was the norm among emerging markets in the past, and thus may be relatively well-positioned for their small equity markets to develop.

Investor interest in emerging markets in the early 1990s owed a great deal to the introduction of Brady Bonds, named after Treasury Secretary Nicholas Brady of the George H.W. Bush administration. These instruments enabled a number of nations, particularly in Latin America, to restructure their foreign debt and gain credibility as plausible environments for equity as well as fixed-income investment.

The mid- to late 1990s saw renewed turbulence in emerging markets, with Mexico’s peso crisis of 1994, Thailand’s 1997 devaluation of the baht and Brazil’s 1999 retreat from the dollar peg of its currency, the real. However, by early in the current decade, investor confidence in emerging markets was on the upswing again, strengthened by reformist policies such as Brazil’s embrace of inflation targeting. The MSCI Emerging Markets Index, which peaked vis-?-vis the MSCI World Index in 1994 and then lagged behind it in the late 1990s, resumed beating the global benchmark handily in 2003.

Longer History