If the idea of frontier markets is intimidating, keep in mind that China, Brazil, and India wore this label not all that long ago. Look at them now.
No one is suggesting that an entire portfolio, not even a significant slice, be devoted to such high-risk areas as Africa, the Middle East, and parts of Asia and Latin America. But struggling economies in the developed world continue to challenge conventional investment thinking. And many emerging markets have essentially joined the "developed" ranks. It may be time to extend your research to the far-flung corners of the globe to find that impressive longer-term growth story.
[See Where to Invest in 2012.]
"Quite simply, these countries are tomorrow's emerging markets," said Oliver Bell, manager of T. Rowe Price's Africa & Middle East Fund, in a research note. "The long-term expectation is that things will continue to improve, and you can see the seeds of that progress now."
Investors who think emerging markets will provide a convincing higher-risk/higher-reward supplement to a U.S.- or developed nation-focused strategy may be disappointed to learn that emerging markets have become highly correlated to the broader stock market, says Brian Gendreau, a market strategist for Cetera Financial Group.
"You might pick [emerging markets] for other reasons, but not diversification," says Gendreau, also a professor of finance at the University of Florida who has taught courses on emerging markets.
Frontier is changing. Why expand your view? GDP growth rates of more than 6 percent, falling government debt levels, improving infrastructure, and heightened national efforts to control inflation combine to paint an improved picture for more risk-tolerant investors. In some areas, bank reform, industry privatization, and tighter corporate governance also help. Plus, much younger populations and a slowly but steadily expanding middle class set up a strong demand trajectory for the coming years.
Frontier markets are positioned to take advantage of swifter technological changes than in even the recent past. For instance, smartphones allow millions of Africans to pay bills and transfer balances thanks to a mobile-phone service developed by network provider Vodacom. The service has almost 48 million customers in five sub-Saharan countries—many without ready access to banks, according to the T. Rowe Price research note.
At the country level, it's a story of aggressive debt-reduction in some cases. In Africa, for example, nations' debt-to-GDP ratio has fallen from 60 percent in 2001 to 20 percent in 2011, according to the International Monetary Fund (IMF). By contrast, developed countries' debt-to-GDP ratio has jumped from about 46 percent in 2007 to more than 70 percent in 2011, the IMF says.
Middle Eastern countries are tackling their debt problems. To be sure, enormous wealth from energy reserves has long supported the six Gulf Cooperation Council countries (Bahrain, Kuwait, Oman, Qatar, the United Arab Emirates, and Saudi Arabia). But some have had large sovereign debt loads that now are steadily declining, the IMF says.
For investors, careful selection is the key. Gonzalo Pangaro, manager of the T. Rowe Price Emerging Markets Stock Fund, emphasizes: "We invest in stocks, not countries, and seek out attractive companies anywhere outside developed markets that are taking market share in industries that are growing faster than GDP."
The researchers highlight Nigeria, where growth prospects stand in contrast to the slower-growth scenario for developed South Africa. Nigeria's economy grew by an annual average rate of 8.7 percent from 2000 to 2010, according to the IMF. T. Rowe's Bell credits the reform government's determination to clean up the country's financial system. "It has gotten tough on mismanagement and corruption and allowed only the well-managed, healthy banks to continue operating normally," Bell notes.
In some cases, fund managers are looking to fold in some frontier exposure in their emerging- and even developed market-focused funds.
T. Rowe's Emerging Europe Fund, for instance, includes companies in Ukraine and Kazakhstan, which are both considered frontier markets. In Kazakhstan, which is rich in natural resources, the Emerging Europe Fund holds shares of copper producer Kazakhmys. As Ukraine's economy remains highly dependent on demand for its steel and agricultural products, the fund owns a U.K.-listed iron ore producer Ferrexpo for its exposure.
The risks. The greatest risk in these still-volatile markets tends to lie with low foreign ownership of stocks and bonds, which can equate to thinly traded and illiquid conditions. What's more, corruption persists, market regulation can lag, and geopolitical tensions can prove disruptive. And, as with any investment, valuation must be considered—some areas present better deals than others. Over the last decade, frontier markets outperformed emerging markets in a few years, but lagged emerging markets overall and were generally more volatile.
Cetera's Gendreau notes that among the handful of currently active frontier-market exchange-trade funds (ETFs), the bias leans heavily toward Middle East markets. That means commodity price fluctuation—oil in particular—will sway these equity returns. And oil, of course, is vulnerable to swings in political sentiment.
Still, it's never too early for research. Investors can start by tracking the MSCI Frontier Markets Indices, found at www.msci.com.