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.