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Whatever your take on the global markets, especially viewed against the backdrop of Federal Reserve policy, you need to understand the range of products that are available. "Investing in Frontier Markets: Opportunity, Risk and Role in an Investment Portfolio" (Wiley, 2013) by Gavin Graham and Al Emid introduces readers to one of the least understood asset classes.

For starters, it’s important to define emerging markets as a whole and then to isolate the frontier markets subset. Emerging markets are defined as those countries with a GDP per capita of less than $12,476 that are included in the MSCI Emerging Markets Index. Frontier markets “are investable but have lower market capitalization and liquidity, or more investment restrictions than the more established emerging markets, or both.” (p. 3) Forty countries are included in both the MSCI and S&P frontier market indices—eleven from sub-Saharan Africa, five from Asia, ten from Eastern Europe, six from Latin America, and eight from the Middle East and North Africa. To give a sense of what countries are considered frontier markets, the Asian representatives are Bangladesh, Kazakhstan, Pakistan, Sri Lanka, and Vietnam. The Latin American countries are Argentina, Colombia, Ecuador, Jamaica, Panama, and Trinidad and Tobago.

Why invest in frontier markets? The key benefits, the authors contend, are “diversification, a low correlation with developed markets and the strong likelihood of frontier markets mirroring the development path followed by longer-established emerging markets, thus delivering strong returns to investors with long-term horizons.” (p. 2)

There are reasons to be cautious about investing in frontier markets, however, most notably their recent returns. In the five years ending August 2012 frontier markets have significantly underperformed emerging markets: -9.83% per annum versus -0.07% per annum. Over a ten-year period they returned 8.33%, whereas emerging markets returned 15.35%.

Frontier markets also exhibit high volatility, in part because “there are no, or very few, … institutional investors to offset capital flows generated by individuals and foreign investors.” (p. 75) But high volatility does not imply high portfolio risk because “frontier markets not only have low correlation with developed and emerging markets but very low correlations with each other.” (p. 74)

Let’s say that you would like to invest in frontier markets. What’s the best way to go about it? There are (in order of popularity) global frontier market funds, ADRs, individual equities in multinational companies with major exposure to frontier markets, single-country funds, sector funds, regional funds, and ETFs. The authors recommend using an actively managed global fund with a reasonable expense ratio (2.1%-2.3% per annum). The largest is the Templeton Frontier Markets Fund. Its U.S. version launched in October 2008, and returned 13.45% per annum from inception to the end of 2012 after deducting a 2.15% management expense ratio; during this same period the MSCI Frontier Markets Index had a negative return of 4.98% per annum. Two other outperforming funds are the Harding Loevner Frontier Emerging Markets Fund and the HSBC GIF Frontier Markets Fund. This outperformance is easy to understand. “Given the extremely concentrated and illiquid nature of the frontier market equities that passive investments such as ETFs have to invest in, it is unsurprising that active managers have beaten the indexes. They are inefficient markets where active managers find it much easier to add alpha by virtue of research and taking positions away from the index weightings.” (p. 221)

The most obvious audience for Investing in Frontier Markets is financial advisors who have to explain to clients the pros and cons, the ins and outs, of adding this asset class to their portfolios. They will definitely be better informed after reading this book.

Source: Book Review: Graham and Emid, 'Investing in Frontier Markets'