Over three years ago, I wrote a Fund Spy column about frontier markets, a group then gaining recognition from the investing public. The idea was that just as Brazil and Korea were once considered obscure destinations that gradually moved into the mainstream--handsomely rewarding some savvy investors over time--countries such as Vietnam and Nigeria would form the next wave.
It is perhaps no coincidence that that column appeared in late April 2007. As it turned out, that was near the top of a more than four-year-long rally in global stocks, and conventional emerging markets had led the way with astounding gains. No doubt some people started thinking that the risks of emerging markets were overblown, so they might as well dive deeper. Others perhaps felt that after such a long rally in emerging markets, those stocks were getting too well known, so it was time to look for more attractive values elsewhere.
As the global financial infrastructure wobbled over the next couple of years, frontier markets received far less attention. But this was revived mid-2010, perhaps due to several funds investing in frontier markets achieving top-of-the-charts returns in the global emerging markets equity category as the bigger emerging markets stumbled. Now, as we approach the end of 2010, emerging markets both big and small find themselves firmly fixed on investors radars. Whether the renewed interest is a danger sign I'll leave to the reader to decide. But comments from emerging markets portfolio managers remain sanguine (see the recent interviews with Schroder's Head of Emerging Markets Equities and Lazard's Developing Markets Fund manager.) Meanwhile, with three and a half years lapsed since the last column, it's time to revisit the frontier markets group.
Explaining the Frontier
Frontier markets--sometimes called pre-emerging markets--are countries considered one step behind emerging markets in stock market sophistication. The factors considered for such an evaluation include the number of companies listed, trading volume, regulatory structure, and how easy it is for outsiders to invest. Of course, no hard-and-fast line separates a frontier market from an emerging market, just as, on the other end of the spectrum, the line can get fuzzy between emerging and developed markets.
That said, there's general agreement on which countries belong in the frontier group. Besides those listed above--Vietnam and Nigeria--there are others in the Middle East such as Qatar and Oman, many sub-Saharan markets such as Kenya and Ghana, and a few in Europe, including Croatia. Note that more-familiar destinations such as China, India, Russia, Brazil, and Mexico, along with Turkey and South Africa, are all considered emerging rather than frontier.
Pros and Cons
Enthusiasts hope that frontier markets will repeat the course taken by the most successful emerging markets. Shareholders in many emerging-markets funds, whether broadly diversified geographically or focussed on a single country, could have reaped huge gains by holding them over a long period. (Those who sold during the periodic crashes or bought at the tops, though, would have received quite different results.) The possibility that the enthusiasts might be right about frontier markets shouldn't be dismissed casually. Although expecting Ghana or Morocco to be the next Brazil or China is a stretch, there are sound companies with strong managements and admirable growth prospects available in many less-travelled corners of the world. Some are available at much cheaper prices than similar companies from more-familiar markets.
However, the risks are considerable. Almost by definition, frontier markets aren't as liquid as emerging markets, much less developed ones, so trying to sell a large chunk of shares (or even a small chunk) during a downturn could be difficult or impossible. Lax regulation can cause other problems, as can shareholder cultures and legal environments that can be even dicier than those in emerging markets such as Russia or China.
The Options
Few broad-based emerging-markets stock funds put much money in frontier markets. (Bond funds are another story.) Those that do seek pure exposure to these markets have little in the way of choice, as those managers wanting to play frontier markets will incorporate them in their mainstream fund. Templeton stands out as having long-standing experience in this field, with Dr Mark Mobius in charge of Templeton Frontier Markets since its launch in 2008. Despite being a new fund, his and his team’s experience in the region extends way back to the late 1980s.
Conclusion
It would be tempting to conclude these funds won't succeed over the long term. But Baring Russia’s 10-year annualised return of 27.8% to 30 November trounces that of the MSCI EM Index’s. So investing in a costly fund that targets a once-obscure market wracked with political risk can, in fact, pay off.
However, whether an investor should take the plunge into a frontier-markets fund, rather than simply relying on a well-constructed portfolio of proven, lower-cost funds with long-tenured managers, is another question. Needless to say, it takes not only hope, and in many cases a blind eye to expenses, to believe in the prospects for these funds, but to benefit you'd also need the fortitude to hang on during some scary headlines and nasty declines. Take note: Though it has that gaudy 10-year record, in the calendar year 2008 the Baring Russia fund lost over 64% and in 1998 the loss exceeded 81%. At times like that, hanging in there is easier said than done.
This article was first published in June 2010 and has been rewritten for a UK audience by Holly Cook, Editor of Morningstar.co.uk.
