With a growing number of ETFs providing access to frontier markets, it’s important to take a step back, understand the category and assess whether these equities are right for your portfolio.
Frontier markets, sometimes referred to as “pre-emerging markets,” are countries with equity markets that are less established – places like Argentina, Kuwait and Bangladesh. They tend to be characterized by lower market capitalization, less liquidity and, in some cases, earlier stages of economic development. As you can imagine, they can be particularly hard to access for foreign investors.
Given that frontier markets are smaller and hard to access, what’s the draw for an investor? There are a few potential portfolio benefits to be aware of:
1) Widened scope. Frontier markets give investors the opportunity to broaden their global exposure, widen their capitalization spectrum, and even gain access to particular areas of growth. For investors looking to complete their international investment exposure, frontier markets can sometimes literally be “the final frontier” of their portfolio.
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Click to enlarge2) Diversification. As emerging markets mature and become increasingly coupled with global developed economies, their risk/return characteristics begin to resemble those of their developed market counterparts. Since frontier markets are lowly correlated to emerging and developed markets, they can add a diversification benefit to a portfolio.
3) Access to growth. Many frontier market countries have low debt-to-GDP levels and offer high economic growth rates when compared with emerging and developed markets. In addition, it’s estimated that ~30% of the global population currently resides in frontier markets – consumers of the future as these countries continue to develop.
Click to enlargeWhen considering an investment in frontier markets, it’s important to note that all exposures are not created equal. The fact that these markets are hard to access can be reflected in the type of securities that some frontier market indexes include. For example, some of these indexes include few if any truly local frontier market stocks, opting instead for U.S and European listed depository receipts, or even up to 50% or more in emerging markets securities.
What differentiates the MSCI Frontier Markets 100 Index -- the benchmark for the recently-launched iShares Frontier Markets ETF (NYSEARCA:FM) -- is that the index puts a strong emphasis on tradability in a number of ways, such as requiring a minimum liquidity level for securities. Because of this, the index includes 100% frontier market equities, rather than relying on emerging market equities to make up for lack of liquidity in frontier markets.
Sources: MSCI, Bloomberg, World Economic Outlook