While frontier markets may be a small, often inaccessible segment of the global investment universe, the asset class has been gaining traction among investors recently.

“Frontier markets, by definition, are at the far edge of the investment universe and are generally not included in global equity indexes or even in many emerging-markets equity funds,” writes Patricia Oey, a senior analyst covering passive strategies on Morningstar’s manager research team, in a new research paper.  

Morningstar released a research paper on Wednesday, “Frontier Markets Begin To Emerge,” that delves into investing in frontier markets and the associated risks.

One of the main reasons frontier-markets equities, which Oey calls “a very tiny and relatively inaccessible asset class,” are gaining interest among certain investors is their outperformance versus emerging markets over the two years through October 2014. Oey attributes this to frontier markets’ “rosier growth outlook” relative to emerging markets.

As China, Brazil and Russia have begun to slow, Oey says many frontier-markets economies are entering a period of mid- to high-single-digit growth. Much of this growth is due to a very low economic base, favorable demographics, growth in infrastructure spending and abundant natural resources.

“And relative to emerging markets,” Oey writes, “certain frontier countries will benefit from the rapid adoption and dissemination of ‘new economy’ services such as mobile banking and mobile payments, which should contribute to growth in the medium term.”

Oey doesn’t deny that frontier markets are risky, citing political instability, social unrest, corruption, disease, terrorism, underdeveloped financial systems and capital markets, and a fickle regulatory environment all as potential risks.

“Investors mulling the merits of this investment frontier should take a closer look before jumping in: The underlying risks and performance drivers are quite different from those in emerging and developed equity markets,” writes Oey.

While the risks in frontier markets are quite similar to those in emerging markets, the probability and potential magnitude of the risks associated with frontier markets are much greater. During the 2008 crisis, frontier markets experienced the largest drawdown. According to Morningstar, the MSCI Frontier Markets Index had the largest maximum drawdown relative to the MSCI Emerging Markets Index and the MSCI EAFE Index, an index comprising developed Asia and Europe equity markets.

“During periods of extreme market stress, frontier markets’ relatively illiquid stock markets can suffer sharp declines in the face of heavy selling,” states Oey in the paper.

While frontier markets, which tend to have a small number of liquid securities and restrictions on foreign ownership, can offer the potential for higher returns and greater diversification benefits in the medium term, Oey says, “investors should carefully evaluate their options.”

“Investors with an above-average risk tolerance may want to consider adding some frontier exposure within their emerging-markets allocation,” states Oey. “However, the risks to investing in frontier markets are many [and] most funds are untested, as they have short track records.”

Best-performing frontier markets

Over the past two years, the best-performing frontier markets have been Argentina, United Arab Emirates, Kenya and Qatar.

Oey calls Kenya, the largest economy in East Africa, a “frontier-markets success story.”

“Relative to its neighbors, [Kenya] has a better-educated population, its economy is more diversified, and it has stronger trade and financial links to the rest of the world,” writes Oey. “Over the past few years, foreign direct investment has been rising, as many multinationals have sought to establish their East Africa hub in Kenya.”

Kenya has many large-cap public companies that are well-run firms with exposure to solid growth trends, such as mobile operator Safaricom, East African Brewers and a number of banks with strong balance sheets.

While Argentina is considered an upper middle-income economy by the World Bank, MSCI classifies the country as a frontier market because of the failure of its heterodox economic practices and strict capital controls. Meanwhile, FTSE announced in September 2014 that it will remove Argentina from its frontier index in June 2015.

Oey attributes some of Argentina’s success to local investors buying shares as a hedge against inflation, as well as investors being optimistic that a new leader will implement reforms that will stabilize Argentina’s economy.

Another possible reason Argentinians have been buying equities, Oey writes, is because “it is reportedly one of the few channels by which they can gain access to the U.S. dollar.”

“Many large-cap Argentinian companies have both a local listing as well as an ADR that trades on the NYSE, so Argentinian investors can buy local shares and then sell ADRs for U.S. dollars,” she states.

One of the key drivers of performance in Qatar and United Arab Emirates’ equity markets, each of which has about 20 liquid stocks, was MSCI’s announcement in June 2013 that it was going to move both countries from the MSCI Frontier Markets Index to the MSCI Emerging Markets Index in June 2014.

“That change means there is now a significantly larger potential investor base for these new emerging-markets countries,” Oey writes, adding that “in the months following the 2013 announcement, both domestic and foreign investors piled into Qatari and United Arab Emirates stocks in an attempt to get ahead of this reclassification.”

This strong market rally prior to their move to the MSCI Emerging Markets Index contributed to the strong performance of the MSCI Frontier Markets Index through June 2014.

 

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