It is not easy to invest in frontier markets and many investors have no exposure to them. While it will not have a large impact on an investor's portfolio to ignore the frontier markets, the cheap valuations, favorable demographics, and low correlation with other markets make them a worthwhile investment.
Frontier markets are countries with investable stock markets, but are too small, illiquid, or unregulated to qualify as emerging markets. Definitions of what exactly constitutes a frontier market vary between the three major index providers, but there is significant overlap between them.
Each index contains securities in South America, Africa, Europe, Asia, and the Middle East, so frontier markets are not exclusive to one region. Some of the largest constituent countries include Argentina, Kuwait, Vietnam, Nigeria, and Romania.
According to FTSE, the market cap of securities in developed markets represents 90.9% of the total world market cap, while emerging markets represent 8.8%. Frontier markets comprise a mere 0.3% of the world's total market cap.
If investors wish to match their investments to the market cap of the world, it would not be out of place to round frontier markets down to 0% and split investments proportionally between the developed and emerging markets. In fact, many investors do just that and have no exposure to frontier markets. But there may be value in investing in frontier markets.
For the do-it-yourself investor who dislikes ETFs and mutual funds, there are some opportunities to invest in frontier markets through US stock exchanges. Investing in individual securities from frontier markets is not for the faint of heart, however.
Argentina offers the largest selection of ADRs for stock pickers, with over a dozen trading on the US exchanges with sufficient liquidity to invest in. Stocks in Argentina have done well over the past several years, as market reforms and an improved political outlook spurred investment in the country. Many investors predicted that Argentina would graduate from frontier market status to emerging market status and bid up the stocks leading into the summer, but they ended up being disappointed. Argentina's stocks have since come back down to earth, but this does provide some opportunity.
One stock which caught my eye was BBVA Banco Frances (NYSE:BFR), which is bouncing along near its 52-week lows. It is a bank that provides financial services to large corporations, small companies, and individuals in Argentina and its valuations are fairly attractive. It has a forward P/E of 9.9 and a trailing P/E only slightly higher than that. If the political and economic situation in Argentina continues to improve, I would expect healthy returns from the stock.
Outside of Argentina, options for direct investing in frontier markets are limited. Cyprus, which is considered a frontier market by FTSE and S&P but not by MSCI, has one ADR which trades on US exchanges: QIWI plc (NASDAQ:QIWI). QIWI provides payment services in Russia and the Commonwealth of Independent States. Panama, which is considered a frontier market by the S&P and MSCI but not by FTSE, has two ADRs worth consideration: Banco Latinoamericano de Comercio Exterior (NYSE:BLX) and Copa Holdings (NYSE:CPA). The first is a bank and the second is an airline. As you can see, financials and industrials are well represented among frontier markets.
If you aren't interested in Argentina, Cyprus, or Panama, investing in frontier markets directly is very difficult for the US investor. While there may be opportunities in these three countries, a better approach might be with an ETF or mutual fund.
My first instinct was to look for actively managed mutual funds, as the illiquid nature of frontier markets would seem to lend itself to outperformance by active management. Emerging markets remain one of the few spaces where active funds can frequently outperform the indexes, and there is enough competitors in the space that one can find reasonable expense ratios and good management if one looks hard enough. I assumed the same would be the case for frontier markets, but I was mistaken.
There is a very limited selection of frontier markets mutual funds, and they are characterized by extremely high initial investment requirements, high annual expenses (of roughly 2%) which often include 12b-1 fees that do not serve investors' interests, and/or front-end loads. Even if you ignore these drawbacks, there are limited pure play frontier market funds to choose from.
If an investor is determined to pay for active management in frontier markets, their best bet would be to find a diversified emerging markets fund that has a broad enough mandate that allows them to also invest in frontier markets. In this way, one could get both emerging and frontier markets exposure at a much more reasonable price.
The ETF world, at least, provides two good options for investing in frontier markets.
Of the two, my preference is the iShares MSCI Frontier 100 Fund for its greater liquidity, larger number of constituents, and lower correlation with developed markets, despite its slightly higher expense ratio.
There are many reasons NOT to invest in frontier markets: high expenses, illiquidity, poor corporate governance, and geopolitical risk foremost among them. This isn't the whole story, though. Most investors are not invested in frontier markets, and this can lead to opportunity.
I would not advocate an enormous allocation to frontier markets, but there are good arguments to be either equal weight or overweight. I personally am overweight both emerging markets and frontier markets, with a little over 9% in emerging markets and a little over 1% in frontier markets (vs. 8.8% and 0.3% if one attempted to match the market capitalization as described by FTSE), and I'm tempted to increase that exposure even further. I added a frontier markets allocation to my portfolio just this past week with a purchase of shares in the iShares MSCI Frontier 100 Fund.
Many investors are not invested in frontier markets, but there are good reasons for them to be. While I have been keeping my eye on one Argentinian ADR, I've decided that the most attractive way to invest in the diverse world of frontier markets stocks is through an ETF. With strong demographics, cheap valuations, and low correlation with other stocks, frontier markets can make a small but important addition to any portfolio.
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Disclosure: I am/we are long FM. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.