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Back to basics: the case for investing in frontier markets

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Frontier markets have been lauded as the "next big thing" in the investment world.

Due to the poor performance of emerging market (EM) equities this year, investors have shunned EM funds and started to look further afield.

Assets under management in frontier market funds have more than doubled to $3.1bn since the start of the year, according to BofA Merrill Lynch, while EM funds have suffered outflows of $2.1bn.

We go back-to-basics and explain the case for investing in these economies…

What are frontier markets?

The definition of what qualifies as a frontier market remains murky, but in simple terms it is a type of emerging market and its characteristics typically include a low to middle income population, a relatively under-developed capital market and less liquidity than an emerging market.

The term ‘frontier market’ can often be applied as a catch-all for all markets that are not designated as eitherathbioba developed or emerging market status.

Currently, the MSCI Frontier markets index comprises 34 markets spanning Asia, Middle East, Eastern Europe, Latin America and Africa.

Examples of frontier markets include: Argentina, Ghana, Iraq, Kenya, Kuwait, Qatar, Slovenia, Sri Lanka, Ukraine and Vietnam.

Why invest in frontier markets?

Generally, they appeal to investors because they offer potential high returns with low correlation to other markets.

The expectation is that over time frontier markets will become more liquid and take on characteristics of emerging markets. The hope is investors can get into the markets just before they enjoy growth such as that seen in China.

However, investing in frontiers can be extremely risky, and investment should only be done with the view to lock away capital for the long term.

What are the main risks?

The main risks with investing in frontier markets are as follows:

Illiquidity – These markets tend to have very little money moving around, unlike in emerging or developed markets. This poses a problem when looking for buyers if you want to sell shares.

Corporate governance – Frontier markets tend to have very poor corporate governance. Investors are generally advised to stick to large, established corporations as much as possible.

Government risk – Frontier markets tend to bring with them heightened risk from political problems. There can be possibilities of a coup or revolt affecting companies in these countries. Governments may also suddenly decide to nationalise companies – think Argentina and Repsol.

Other risks investors face are substandard financial reporting and large currency fluctuations. In addition, many markets are overly dependent on volatile commodities.

What are the main benefits?

Frontier market investments can have a low correlation to developed markets and thus can provide additional diversification to a portfolio.

Other virtues of frontier markets include having some of the world’s fastest-growing economies, with stock markets that trade on attractive valuations and high dividend yields.

Frontier economies also tend to have young demographic profiles and lower government debt.

How do you invest in frontier markets?

Choosing a frontier markets fund can be tricky, as there are few on offer.

However, Mona Shah, co-manager of multi-asset portfolios at Rathbones, tips Renaissance Asset Management’s Eastern European fund as an option for investors wanting to gain access to these markets.

Meanwhile, Ben Seager-Scott, senior research analyst at Bestinvest, highlights the BlackRock Frontiers investment trust, which has returned 48.7% over the year to 9 August, according to Morningstar.

Baring Asset Management is the latest provider to launch a Frontier Markets fund, and Seager-Scott expects many competitors to follow suit over the next ten years.

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