In 1992, Farida Khambata of the International Finance Corporation (IFC), defined frontier markets as those markets that are investable but are less well-developed in terms of size, liquidity, and accessibility than traditional emerging markets. The expectations for countries labeled as having a frontier market is that over time the market may become more liquid and exhibit similar risk/return characteristics as the larger, relatively more liquid emerging or developed markets.

Much of the recent enthusiasm for frontier markets is due to the broad surge in commodity prices over the past few years, as many of these frontier economies derive a significant portion of their revenues from commodity exports. Aside from rising commodity prices, frontier market economies often have benefited from economic reform and changes in government or political structure. Additionally, there are other long-term domestic growth prospects, such as an increase in incomes, technology infrastructure, and living standards, that aid in providing a more open and investable market culture for foreign investors.

Thanks in large part to reduced trade barriers and climbing commodity prices, the incomes of many frontier markets are on the rise. In those countries where governments have instituted sound monetary and fiscal policies, the potential for rapid expansion and inclusion among the emerging markets of the world is quite realistic.

Frontier markets often offer potential for greater payouts relative to developed markets due to numerous inefficiencies in asset pricing and flow of information, but with that potential upside comes increased risk levels. High volatility derived from the heavy dependence that many of these markets have on a single natural resource, can create the potential for a market crash or significant depreciation of invested capital in the event of falling prices. Risks can arise from a wide range of potential issues including, but certainly not limited to, political instability, lack of liquidity, corruption, and limited market regulations.

There are three major indices and many smaller ones that gauge the performance of these markets. They are the MSCI Frontier Markets, the Bank of New York (BNY) Mellon New Frontier DR and the FTSE Frontier index. The requirements for inclusion in these three indices are quite different from one another.

The markets in the MSCI Frontier Markets index are analyzed and evaluated for inclusion based upon four market accessibility criteria: openness to foreign ownership, ease of capital flows, efficiency of the operational framework, and stability of institutional framework.

The Mellon New Frontier DR Index tracks the performance of American Depositary Receipts (ADR) and Global Depositary Receipts (GDR) of frontier market companies. In order for a company to be included in this index, it must meet the following criteria: market capitalization greater than $100 million, share price greater than $3, minimum of 10 days traded during previous three months, average daily volume greater than 10,000 shares.

The FTSE Frontier Index tracks fifty of the most liquid stocks from a universe of twenty-three frontier markets. A country must meet the following five criteria to qualify as a frontier market: formal regulatory authority actively monitoring the market; no significant restrictions or penalties for capital repatriation; failed trades occur rarely; clearing system that takes not more than seven days; and adequate transparency.

Frontier markets can aid in diversifying a portfolio as well as help to add alpha. Currently, there are few passageways to invest in frontier markets, mostly due to the high cost of operating in such illiquid environments. Typically, we believe that investors should avoid investing directly in individual stocks in these types of markets unless the individual intimately knows and understands the dynamics of that particular company, and the market environment. Access to frontier markets for investors worldwide is difficult to obtain, but that is continually changing as new mutual funds and exchange-traded funds (ETF) are offered.

Two of the larger ETFs that focus on a collection of frontier markets are the Claymore/BNY Mellon Frontier Markets (FRN) and the PowerShares MENA Frontier Countries (PMNA). The Claymore/BNY Fund is constructed to closely track the performance of The Mellon New Frontier DR Index. The PowerShares MENA Frontier Countries ETF tracks the NASDAQ OMX Middle East North Africa Index. This is a focused fund geographically and so does not contain many of the countries normally associated with frontier markets.

Aside from using an exchange-traded fund, an investor could gain exposure to frontier markets through select mutual funds. For instance, the T. Rowe Price Africa and the Middle East mutual fund (TRIAX) aims to achieve long term growth of capital by investing primarily in the common stocks of companies which are located or have primary operations in Africa or the Middle East. Alternatively, investors might consider the Templeton Frontier Markets Fund which was the first U.S. mutual fund to focus on the growth opportunities in frontier markets.

Frontier markets can provide significant upside to a portfolio but can, of course, lead to a total loss on investment. All of the previously mentioned vehicles for investing in frontier markets were created in either 2008 or 2009. Hence while the recent performance of many of the frontier market funds and ETFs has been strong, one should be careful not to draw long-term conclusions from strong short-term performance. In addition, the risk for these portfolios, as measured by standard deviation, has generally been quite high relative to the broader market (S&P 500 index).

As frontier markets are largely uncorrelated to the larger, developed markets, finding an optimal way to invest in the frontier market could prove to be quite helpful in diversifying a portfolio, especially during uncertain economic times. The risks associated with these investments, as previously stated, can be overwhelming and difficult to monitor. For this reason, a mutual fund or an exchange-traded fund might be the less risky option for clients. However, balancing a client’s desired level of risk and portfolio objectives will serve as the ultimate guide in determining whether exposure to frontier markets is appropriate for a client.

Written by Gavin Raphael, CIMA, director of research, Cary Street Partners, Richmond, Va., and Matthew Shaia, associate analyst, Cary Street Partners.

Although the information contained in this article is based on generally available information or obtained from sources believed to be reliable, the accuracy and completeness is not guaranteed. This article is not an offer or solicitation to purchase or sell any financial instrument. Certain transactions and trading strategies, including those involving alternative investments, futures, options, and high-yield securities, give rise to substantial risk and are not suitable for all investors. No liability whatsoever is accepted for any loss (whether direct, indirect or consequential) that may arise from any use of the information contained in or derived from this article. Past performance may not be indicative of future results.

Investing in foreign securities presents certain unique risks not associated with domestic investments, such as currency fluctuation and political and economic changes. This may result in greater share price volatility. The funds mention in this article may focus their investments in certain geographical regions, thereby increasing their vulnerability to developments in that region. This may also result in greater share price volatility.

Investors should consider the investment objectives, risks, charges and expenses of a mutual fund carefully before investing. This and other important information is contained in the funds’ prospectus; read and consider them carefully before investing. All ETFs are subject to risk, including possible loss of principal.

Cary Street Partners is the trade name used by two separate limited liability companies, Cary Street Partners Investment Advisory LLC, a registered investment advisor; and Cary Street Partners LLC, a registered broker-dealer and a member of FINRA and SIPC.