With all the turmoil in emerging markets recently, some investors may be especially wary of investing in so-called frontier markets, traditionally the riskiest areas of the emerging world.
But investors shouldn't assume that frontier markets are the same as their emerging market counterparts. Just as I view emerging markets as a strategic asset class worth having some exposure to, frontier markets are a separate asset class deserving of their own strategic allocation. Here are three reasons why I view frontier markets this way.
Frontier markets have experienced more robust growth than emerging markets. Unlike their larger emerging market counterparts, many frontier markets are experiencing no slowdown in growth. In fact, while frontier markets, which are mostly concentrated in the Middle East and Africa, are small, they have exhibited consistently strong gross domestic product (NYSEMKT:GDP) growth in recent years. Economists expect this trend to continue due to frontier markets' favorable demographics and the increasing investment in frontier markets' vast untapped natural resources.
Frontier markets haven't performed in lock step with the more developed emerging world. Over the past year, frontier markets, as measured by the MSCI Frontier Markets Index, have delivered a stellar return of 21%, as compared with a loss of 5% for broad emerging markets. Why the difference? Since the Federal Reserve first hinted at a taper last May, emerging market stocks have suffered a steep sell-off on the back of capital outflows and growth concerns. By contrast, frontier markets have been relatively insulated from bouts of capital flight thanks to their robust growth, still low level of foreign ownership and pegged currencies.
Frontier markets have a much lower correlation with the global market than emerging markets. Because frontier markets are less developed than their emerging market counterparts, they are less tied to the global economy. As a result, frontier market stocks don't always move with the equities from the rest of the world. Drilling down into how much less correlated they are with the global market, over the past three years on average, frontier stocks have had a correlation of 0.5 with global equities, while emerging market equities have had a correlation of 0.85.
In addition, it's worth noting that frontier market stocks from different countries are also less correlated to each other as compared with the correlation between equities from different emerging market countries. This, in turn, has helped frontier market stocks display less volatility in recent years as compared with emerging market equities.
To be sure, frontier markets are still a very volatile asset class and investors should be mindful of the typical risks associated with these exotic markets, which are still at an early stage of economic development. These risks include political instability, corporate governance issues, high inflation and low liquidity. Frontier markets are a relatively new asset class, meaning liquidity is still a work in progress and it's not an asset class you want to trade in and out of. Moreover, since many frontier countries hold the majority of their reserves in commodities, falling commodity prices also represent a risk to the markets.
What does this mean for investors? While frontier markets can potentially be a good source of portfolio diversification and are worthy of an allocation, allocations to them should be small given the risks involved, with the exposure amount varying depending on an investor's risk tolerance. Still, I continue to advocate that investors expand their definition of the emerging world to include frontier markets. The bottom line: Frontier markets and emerging markets are not created equal, and they both deserve a spot in investors' portfolios.