Frontier markets have been gaining attention from
and investors alike in recent months.
The MSCI Frontier Markets Index has outperformed its developed
and emerging market counterparts so far this year, as investors
have been searching for growth and bargains in a slow-growing
world where most major asset classes appear fully valued.
However, despite frontier markets' increasing popularity, many
investors are approaching frontier stocks too narrowly, viewing
them as a subset of their emerging markets' allocation and
selling off part of their emerging market equities' exposure to
gain access to the frontier.
As my colleague Kurt Reiman and I write in our new Market
Perspectives paper, "
Investing on the Frontier
," frontier markets should not be lumped in with emerging markets
and instead, they should be viewed as a separate asset class,
view I've been advocating for a while
. As we write in our new paper, there are three reasons why
investors should now consider having a portfolio allocation,
albeit a small one, to frontier markets over the long term, while
maintaining their exposures to developed and emerging
The potential diversification benefit.
Two to three decades ago, when emerging markets were at an
earlier stage of development, their stocks weren't that
correlated with those developed markets. However, over the last
25 years or so, emerging markets have become more global. As a
result, stocks in emerging markets like China and Brazil now
actually have a high correlation with U.S. and European equities,
meaning they all tend to move in the same direction.
Most of the countries that dominate frontier markets, on the
other hand, are very locally oriented. They're local banks and
agriculture companies that are very tied to the local economy.
This means that frontier market stocks have a lower correlation
with other equity markets than emerging market equities. In
short, with frontier markets, you're potentially getting back a
little bit of that lost diversification benefit that you used to
get from investing in emerging markets.
Equities, in general, come with a lot of volatility and frontier
markets are no exception. Still, on a relative basis the
volatility of frontier markets has historically been lower than
you might expect. Because frontier market stocks are less
correlated with each other compared with the correlation between
equities of various emerging markets, frontier market stocks'
volatility has historically been below that of emerging markets.
As such, frontier markets have, at least historically, helped
provide upside potential for even conservative-leaning
Frontier market economies seem poised to grow faster than both
developed market and emerging market economies over the next few
decades. This is partly thanks to frontier countries' generally
better demographics. Unlike emerging markets, based on United
Nations data, frontier markets universally have
young, growing populations, which, over the long
term, are mostly good for economic growth
In addition, frontier market countries are in
very early stage of growing per capita income
. The advantage of being in an early stage is that it's easy to
catch up- frontier countries can basically adopt technology from
more established markets and use it to accelerate their growth
However, while there is a strong case for embracing the
frontier, it's important to recognize that markets in the
so-called "pre-emerging" world are not without significant risks.
Not only do you have the same risks you'd have with any developed
and emerging market, but there also are a number of risks
specific to the frontier.
There is a higher risk of political turmoil in frontier market
countries, of course. Plus given that frontier markets are at
relatively early stages of development, particularly with respect
to their financial markets, they offer limited liquidity. The
high concentration of financial stocks in frontier markets also
means that these markets could be hurt if there is a global
banking sector downturn. Finally, frontier markets also could
suffer if investors regain enthusiasm for emerging markets.
To be sure, given frontier markets' strong showing in recent
years, many investors are wondering whether they should still
consider investing in the frontier, especially considering the
risks mentioned above.
My take: It's certainly true that frontier markets have had a
big run this year and they're not without their risks, but their
diversification benefits, lower volatility and growth potential
warrant their inclusion as a long-term strategic holding in most
portfolios, with one caveat. Given that the asset class is now
closer to being fully valued, investors may want to use
dollar cost averaging
to slowly gain exposure to frontier stocks.
Sources: BlackRock, Bloomberg
Russ Koesterich, CFA, is the Chief Investment Strategist
for BlackRock and iShares Chief Global Investment Strategist.
He is a regular contributor to
and you can find more of his posts
Diversification and asset allocation may not protect
against market risk or loss of principal.
International investing involves risks, including risks
related to foreign currency, limited liquidity, less government
regulation and the possibility of substantial volatility due to
adverse political, economic or other developments. These risks
often are heightened for investments in emerging/ developing
markets or in concentrations of single countries. Frontier
markets involve heightened risks related to the same factors
and may be subject to a greater risk of loss than investments
in more developed and emerging markets.