Frontier and emerging markets have been a hot topic for some time, but they are especially interesting as we watch and take part in a world that is quickly changing and adapting.
Even though there are risks associated with frontier markets, they offer unique opportunities that you may find intriguing and helpful as you consider how to build or reallocate your portfolio in the coming year.
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What Are Frontier Markets—How Markets Are Evaluated & Why It Matters
Frontier markets consist of equity markets of countries that are in the early stages of economic development with less liquid financial markets and limited foreign investor access compared to developed countries.
MSCI, a leading provider of indexes and analytics, classifies varying markets into one of four categories:
- Developed Markets
- Emerging Markets
- Frontier Markets
- Standalone Markets
Depending on which of these categories a market fits into, it is placed within a corresponding index. Why does this matter? Well, depending on what index or market your country is classified under, investors are more or less likely to invest, which drives future performance and capital growth.
It’s a big deal for a country to move from an emerging market status to a developed market status. Just as important is when a market bumps down in status. Turkey and Argentina, for example, ran the risk of downgrading in 2021.
So what criteria must a country meet in order for its stock market to be included in one of these categories?
MSCI evaluates using The Global Market Accessibility Review. Each market is evaluated against 18 different metrics, but the main considerations are:
- Market Accessibility—How hospitable is a market to foreign investors? What are the regulations, qualifications, and rights of outside investors?
- Economic Development—What is the historical consistency and growth of the market? Have the rules, regulations, and participation from within and outside proven steady?
- Liquidity—How easy is it to buy and withdraw funds within the market?
- Market Size—How much opportunity is there for growth? Are there caps on any investment instruments or foreign participation? What is the percentage of domestic involvement? How large is the country itself?
The entire market structure and trading framework are considered. If a country scores perfectly in all 18 metrics, then it is placed in the Developed Market. If there are no major issues but room for improvement, the country is placed in the Emerging Market. If there’s significant room for improvement and development, it is placed in either the frontier or standalone market.
Market classification leads to placement in one of the MSCI market indices. These include:
- The MSCI World Index (23 countries)
- The MSCI Emerging Markets Index (27 countries)
- The MSCI All Country World Index (the combination of both the World and Emerging Markets Indices)
- The MSCI Frontier Market Index (27 countries)
Standalone markets are not included in any formal index.
Our focus today is on Frontier Markets—the performance of the MSCI Frontier Market Index and your considerations & options for investing.
Why are Frontier Market options compelling investments and what makes them stand out from other markets?
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Frontier Markets vs. Emerging Markets
2.2 billion people make up the frontier market. That’s one-third of the world’s population. What’s surprising is that these 2.2 billion people only produce 3.5% of the world’s gross domestic product (GDP). And the frontier market only makes up 1.0% of the global stock market capitalization with only 81 stocks (compared to 3,000 in the All Country Index and 1,400 in the Emerging Markets Index). Even though there are 17 countries that make up the frontier market, there are only a couple that dominate the arena. Vietnam and Morocco account for 30.0% and 12.0%, respectively.
So why invest in frontier markets instead of emerging markets? Here are a few key differences between frontier markets and emerging markets:
- Frontier markets are saturated with local investors vs. emerging markets which are strongly influenced by foreign investors. Because frontier markets are more influenced by local investors and events, the markets move on their own—largely uninfluenced by global events.
- Frontier markets are generally on the front lines of urbanization vs. emerging markets which have already urbanized. This creates a potential for growth as an investor, since there’s plenty of room for further development in frontier markets.
- Frontier markets are riskier than emerging markets, but emerging markets are more volatile. More on this in a bit.
- Frontier markets have a larger working-age population than emerging markets.
Frontier Markets vs. Emerging Markets
- More local investors
- Less influenced by global events
- Almost urbanized
- Larger working-age population
- More foreign investors
- More influened by global events
- More volatile
The Benefits of Investing in Frontier Markets
So why should you consider investing in frontier markets? There are several benefits that set frontier markets apart. Here are a few:
- Demographics: The working-age population makes up the majority of the total population, creating strong potential for greater economic output. More economic output creates a trickle effect, with companies earning more and higher returns on stocks.
- Urbanization: The U.N. predicts that 77.0% of frontier markets’ populations will live in urbanized areas by 2050, compared to 68.0% today. Urbanized areas statistically produce more product per hour of work.
Now, all of this sounds wonderful, but it is always important to take a step back, check the facts, and know the risks.
Considering the Risks & Knowing Yourself
Like the MSCI market indices, we need to take into consideration what is influencing these frontier markets. What is the political culture like? Is there a high level of corruption? How developed is the infrastructure, such as roads, bridges, and utilities? How easy is it to create new businesses and how easy is it to withdraw from the market if need be? Can the businesses and culture adapt?
As with any investment, you need to be aware of the risks before jumping in. Frontier markets are a unique investment choice, and they come with unique risks:
- Liquidity Risks: Frontier markets are made up of small companies and businesses. This can make it difficult to trade stocks, especially if most of the trading is being done by foreign investors and not being balanced by both domestic and foreign interests. If there are limits to how much of a company can be owned by foreign investors, that can make it even more challenging to trade down the road.
- Capital Control Risk: An interesting example of capital control risk leading to distorted performance is Vietnam. While the government opened up the market to more foreign investors and incentivized business creation, they put a limit on the percentage a company could be foreign-owned. This led to stocks selling at a premium, because if the cap had been hit for foreign ownership, an interested foreign investor would have to purchase from another foreign investor who already owned stock. This led to distorted performance because stocks were selling at differing rates within the domestic market.
- Governance Risk: It’s important to consider the size and diversity of the company or financial boards associated with the ETF or stock you are considering. One study demonstrated that the larger and more diverse the board was (how open it was to foreign contribution as well as domestic), the better the stock & company performed. The problem is many of the boards within the frontier markets are small and dominated by their domestic spheres of influence.
- Foreign Exchange Risk: One of the reasons frontier market governments enact capital controls is because the inflow and outflow of the U.S. dollar can create a more volatile domestic currency. Nigeria, for example, saw their domestic currency—the naira—devalue three times between 2020 and 2021. This not only poses a risk for foreign investors, but the government had to enact capitol controls so that the influx or withdrawal of foreign funds didn’t detrimentally impact their economy.
Historical Frontier Markets Performance
So how have frontier markets performed in the past? First, let’s consider the valuations. Frontier markets are not cheap—historically nor currently. In early 2022 the MSCI Frontier Market Index had a dividend yield of 2.7%. That’s not bad, but the average dividend yield since 2008 is 4.2%.
Like much of the world, the earnings of companies in frontier markets have rebounded from the pandemic-induced recession. In 2021, frontier market earnings increased 13% on average. Investors are paying up for that earnings growth, though. The PE (price-to-earnings ratio)—what investors are willing to pay for a dollar’s worth in earnings—is higher than average. The P/E is 15x compared to its long-term average of 13x. If we compare that to developed and emerging markets, collectively their P/E is 20, about the same as the long-term average.
If we look at the past decade, the MSCI Frontier Market Index has trailed global stocks as measured by the MSCI All Country World Index (6.9%% vs. 11.2% annualized for the ten years ending January 31, 2022). Frontier markets have outperformed emerging markets for the same decade (6.9% versus 6.1% annualized), but have lagged emerging markets for the past five years (7.4% versus 9.2% annualized).
We don’t know how frontier markets will perform in the decade ahead, but the favorable demographics for their working-age population is a positive. As long as the risks outlined above can be contained, frontier markets should perform at least as well as they have historically.
Frontier Market ETFs & Other Investment Options
What are your options for investing in frontier markets?
There are several opportunities, and you may be drawn to a specific one based on the needs of your portfolio or your personal interests. Here are some of the options:
Frontier Market Exchange Traded Funds (ETFs)
- ishares MSCI Frontier 100 ETF (FM), which focuses on Vietnam, Kuwait, Morocco, Kenya, Romania, and Nigeria. This ETF mainly consists of financial companies, communications companies, and real estate.
- Global X Next Emerging & Frontier ETF (EMFM), which focuses on Saudi Arabia, Thailand, Indonesia, Malaysia, and Mexico.
Frontier Market Funds
- Frontier Market Funds are another way you can invest, with options such as equity funds, fixed interest funds, mixed allocation funds, and real estate. These options can provide you with a more focused or hands-on approach.
If you are looking for non-traditional investment options, you may want to check out Frontier Market News for a more comprehensive list.
It’s Not as Volatile as You Might Think
Even though frontier markets carry quite a bit of risk, they are actually less volatile than emerging markets and about the same as developed markets.
The annualized standard deviation from the MSCI Frontier Market Index over the past 10 years is 13.6% versus 13.2% for developed markets. Those numbers are much less than the annualized standard deviation of emerging markets, which came in at 17% for the past decade. In its worst year (2008–2009), the frontier market index did lose more percentage-wise than the other markets, but historically it has proven less volatile.
Why is this?
Russell Investments explains it this way, “In emerging markets…we often see additional sources of volatility because more international investors have capital at stake. For example, global risk aversion resulting from policy announcements from the Federal Reserve System would likely have an impact on emerging markets. As a result—although it appears counter-intuitive—we often see higher volatility in emerging markets, despite the higher risk in frontier markets.”
Frontier Markets Are Worthwhile—But Take it Slow
We’ve explored the risks, benefits, and various ways you can invest in frontier markets. But is it a worthwhile investment? In a nutshell, yes.
Frontier markets can help provide diversification for your portfolio and offer potential for single-digit returns.
Between the young working population, its progress towards urbanization, and its relative freedom from global influence—frontier markets pose an intriguing and exceptional investment opportunity.
The key, however, is to take it slow. You don’t need to invest much in frontier markets for it to make a difference in your portfolio. You don’t want to overweight yourself in any area, and frontier markets are no exception.
Also, realize that the frontier market option is a long-term game. You probably won’t see high returns immediately, but there is a hopeful outlook for the long haul. If you decide to invest in frontier markets, put just a little bit in and be patient.
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Emily Boulter is a professional writer with a B.A. in English & Writing from Regent University. With experience in show notes writing, grant writing, and business writing, she has a deep passion for helping others through her writing and non-profit initiatives. Emily lives in the Rocky Mountains of Colorado and can easily be found hiking, horseback riding, or reading in one of the local coffee shops.
David Stein is the founder of Money For the Rest of Us. Since 2014, he has produced and hosted the Money For the Rest of Us investing podcast. The podcast reaches tens of thousands of listeners per episode and has been nominated for ten Plutus Awards and won one. David also leads Money for the Rest of Us Plus, a premium investment education platform that provides professional-grade portfolio tools and training to over 1,000 individual investors. He is the author of Money for the Rest of Us: 10 Questions to Master Successful Investing, which was published by McGraw-Hill. Previously, David spent over a decade as an institutional investment advisor and portfolio manager. He was a managing partner at FEG Investment Advisors, a $15 billion investment advisory firm. At FEG, David served as Chief Investment Strategist and Chief Portfolio Strategist.
Podcast Episode 347: Should You Invest in Frontier Markets?
What are the risks and opportunities of investing in frontier equity markets.
Topics covered include:
- What are the criteria used to determine whether a country’s stock market is considered a frontier, emerging, or developed market
- Why some countries aren’t included in any MSCI stock index
- How large are frontier markets in terms of population, economic output, and equity markets
- How frontier market’s favorable demographic profile make them attractive, but might not lead to higher investment returns
- What are the risks of investing in frontier markets
- How expensive or cheap are frontier markets
- What have been frontier market’s historical returns, volatility, and maximum drawdowns
- What are ways to invest in frontier markets
Welcome to Money for the Rest of Us. This is the personal finance show on money, how it works, how to invest it, and how to live without worrying about it. I’m your host, David Stein. Today is Episode 347. It’s titled, “Should You Invest in Frontier Markets?”
MSCI Index Classifications
This week, MSCI, a leading provider of indexes and analytics is issuing its annual classification review report. In this report, MSCI classifies a particular country’s stock market, ranks it whether it’s a developed market, an emerging market, a frontier market, or a standalone market. Those classifications then are used to determine what index the particular country or market is in. We’ll look at the differences between those broad categories.
But this is a big deal for countries because if they move up to a developed market, or from frontier to emerging markets, that can attract additional investment and capital flows into the country. Conversely, there’s the potential to be downgraded to a lower-tier market. MSCI analyzes over 80 markets. 23 are considered developed and comprise the MSCI world index. There are 27 emerging markets that make up the MSCI Emerging Markets index, and combined, the 23 developed countries and the 27 emerging markets countries, make up the MSCI All Country World Index (ACWI). Except that index, the ACWI, doesn’t actually include all countries. There are 27 frontier markets and 11 standalone markets which don’t even meet the criteria for inclusion in the Frontier Market Index.
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