What Are Frontier Markets?

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Frontier markets refer to equity markets in small nations that are at an earlier stage of economic and political development than larger and more mature emerging markets. In other words, think of frontier markets as the smaller siblings of emerging markets. Frontier equity markets typically have modest market capitalization, limited investability and liquidity, and few market information sources. On the positive side, they generally possess favorable demographics and good long-term growth prospects. As these markets probably constitute the last frontier of investing in an increasingly interlinked global economy, investors should be aware of their risks and rewards, and the options available to invest in them.

Characteristics of Frontier Markets

The term "frontier markets" is widely attributed to the International Finance Corporation (IFC), which coined it in 1992 to refer to a subset of emerging markets. Standard & Poor's bought the IFC Emerging Markets Database in 2000 and subsequently established a frontier index in 2007.

As of September 2013, frontier indices had been established by four major providers – Standard & Poor's, MSCI, Russell Investments and FTSE. The number of frontier markets in these indices ranges from 25 in the MSCI index to 41 in the Russell Frontier Index. These frontier markets are generally concentrated in Eastern Europe, Africa, the Middle East, South America and Asia. The biggest frontier markets are Kuwait, Qatar, the United Arab Emirates (UAE), Nigeria, Argentina and Kazakhstan.

The criteria for inclusion in a frontier markets index are not rigid. The starting point in evaluating a nation for inclusion, of course, is that it should not already be a component of one of the numerous emerging market or developed market indices. Assuming that a nation is not, most index providers evaluate parameters such as its economic d! evelopment, market accessibility, liquidity and foreign investment restrictions. Overseas investor interest is also considered, since there is no point in going to the effort and expense of including a nation in a frontier markets index if there is little interest in it as an investment destination.

Emerging to Frontier (and Vice Versa)

The subjectivity involved in classifying a market as a "frontier," rather than an emerging, market means that there are occasional inconsistencies in classification among the different index providers. For example, Pakistan is classified as a frontier market by S&P, MSCI and Russell, but is regarded as an emerging market by FTSE.

There is also some degree of migration between the frontier and emerging markets as their economic fortunes change. As an example, in 2009 MSCI re-classified the status of three countries from emerging market to frontier market – Jordan, Pakistan and Argentina. Morocco will be moved from the list of emerging markets to frontier markets in November 2013.

Movement from the ranks of frontier markets to emerging markets is also possible, as evidenced by the fact that Qatar and UAE will be making this transition in May 2014.

Sector Similarities, Economic Disparities

The biggest sector in any frontier market index by far is banking/financials, which generally accounts for more than 50% of the index. Other sectors with double-digit weights are industrials and telecoms. Sectors such as health care, utilities and consumer discretionary – which form a substantial portion of the benchmark index in bigger economies – typically have minimal representation in frontier market indices.

Despite the large number of Middle East nations and OPEC producers included in frontier markets, energy companies do not find much representation in these indices. This is because most of the big oil and gas companies in these nations are sovereign entities that are largely or wholly owned by the government, so they a! re not op! en to investment by the general public.

Another point worth noting is that since frontier markets include a number of prosperous nations, there is a great deal of disparity between the constituents of a frontier index. As an example, Qatar, with its huge energy reserves and rapid growth rate in recent years, had per-capita gross national income of $81,300 and a population of less than 2 million in 2011, according to the World Bank. In comparison, Bangladesh had per-capita income of $1,910 and a population of 153 million in 2011.

Comparing Frontier Market Indices

Here's a basic comparison of the four main frontier market indices (as of September 2013):

S&P Frontier BMI (Broad Market Index) Number of countries – 36

Number of companies – 556

Top five countries – Kuwait, Qatar, Nigeria, UAE, Argentina

Top three sectors – Financials (53.9%), industrials, consumer staples

MSCI Frontier Markets Index Number of countries – 25

Number of companies – 141

Top five countries – Kuwait, Qatar, Nigeria, UAE, Pakistan

Top three sectors – Financials (53.1%), telecom services, industrials

FTSE Frontier 50 Index Number of countries – 26

Number of companies – 50

Top five countries – Qatar, Nigeria, Argentina, Kenya, Oman

Top three sectors – Banks (51%), industrials, telecom

Russell Frontier Index Number of countries – 41

Number of companies – Not known

Top five countries – Kuwait, Nigeria, Qatar, Argentina, Pakistan

Top three sectors – Financial services, energy, utilities

Why Frontier Markets are Important

Frontier markets are worthy of considering for a number of reasons:

Growth potential due to demographics: While frontier market economies have a combined population of 2 billion people – or about 30% of the global population – they account for only 6% of the world's nominal GDP and just 0.4% of global market capitalization. The population of those living in frontier markets is relatively young, with 60% under 30 years of age and an average age of 30.2 years, a decade less than the 40.5 average age of the 1 billion living in developed nations. Labor costs in most frontier markets are also low compared with costs in other nations. This demographic advantage, combined with a debt-to-GDP that is much lower than in the developed world, means that frontier markets have better long-term growth prospects. In 2011, for instance, frontier markets posted an average GDP growth rate of 4.9%, three times faster than the 1.6% growth rate recorded by the 10 largest advanced economies, according to the World Bank. Frontier markets may improve portfolio diversification: While increasing global economy integration means that most developed and emerging markets move in sync with one another, frontier markets have a lower degree of correlation with them. As a result, frontier markets may be effective in improving a portfolio's diversification. Above-average returns: As of Sept. 25, 2013, eight of the 10 best-performing equity markets for the year were frontier markets, with an average gain of 41.5% in U.S.-dollar terms. While these are not typical returns, as they can gyrate wildly from one year to the next, a patient investor with a long-term investment horizon may be able to generate significant returns from frontier markets over time. How to Invest in Frontier Markets

Exchange traded funds (ETFs) offer by far the best way to invest in frontier markets. A summary of some of the leading ETFs follows (data as of Sept. 27, 2013):

iShares MSCI Frontier 100 (NYSE:FM): Tracks the MSCI Frontier Markets 100 Index. Top geographic allocations – Kuwait, Qatar, UAE, Nigeria and Pakistan

Top sector allocations – Banks, telecoms, oil and gas, real estate

Total assets = US$301 million

Guggenheim Frontier Markets (NYSE:FRN): Seeks investment results that correspond to the price and yield performance of the Bank of New York Mellon New Frontier DR Index. This index, in turn, tracks the performance of depositary receipts in ADR or GDR form for companies from countries defined as the frontier market in the LSE, NYSE, NYSE Amex and Nasdaq. Top geographic allocations – Chile, Colombia, Argentina, Egypt and Nigeria

Top sector allocations – Banks, oil and gas, electric utilities, food

Total assets = US$94 million.

PowerShares MENA Frontier Countries Portfolio (Nasdaq:PMNA): Seeks investment results that correspond to performance of the Nasdaq OMX Middle East North Africa (MENA) index. Top geographic allocations – Kuwait, UAE, Egypt, Qatar and Bahrain

Top sector allocations – Banks, real estate, telecoms, venture capital

Total assets = US$14 million.

Risks of Frontier Markets

Liquidity – Liquidity can be an issue for most markets during turbulent times, and especially for frontier markets due to their thin trading volumes. This lack of volume may result in limited liquidity and wide bid-ask spreads in volatile markets. Geopolitical and political risks – Many frontier markets are located in unstable areas, and as a result, geopolitical risk is a real concern. Political change is another issue that should be considered, since a change of government may be accompanied by significant unrest and instability. Inflation – This is a constant threat in some frontier markets, and it may erode investment returns substantially over the long term. Lack of transparency – Most frontier markets suffer from a lack of transparency and have inadequate information sources. Currency risk – The steep decline in some emerging market currencies like the Indian rupee in 2013 highlights the risk posed by investing overseas. While currency risk is a definite issue for frontier markets, it is less so for the Middle East nations such as Qatar and the UAE that peg their local currencies to the U.S. dollar. Conclusion

Despite their obvious risks, frontier markets offer investors the advantages of above-average returns driven by favorable demographics, as well as portfolio diversification. As these markets probably constitute the last frontier of investing in an increasingly interlinked global economy, investors should be aware of their risks and rewards, and the options available to invest in them.