Frontier Markets

I recently came across a research report from Northern Trust Global Investments that was written by Greg Behar and Stefanie Hest, Senior Investment Strategists.  Due to the growth of non-US markets, they are advocating a higher allocation to frontier markets.  A frontier market is in a developing country that has a high economic growth rate and a small, illiquid stock market.  The country is not part of an index such as MSCI Emerging Markets.  Examples of countries classified as frontier would be Bulgaria, Croatia, Lithuania, Romania, Ukraine, Ghana, Kenya, Nigeria, Jordan, Kuwait, Qatar, Bangladesh, Pakistan, Vietnam, Argentina, Colombia and Panama.

Frontier markets had a real GDP growth figure of 4.79%, about equal to emerging markets and two times developed markets.  This trend should be continuing in the future.  From a valuation perspective, they are more attractive than emerging markets.  The trailing P/E (price to earnings ratio) is hovering at 10 (as of 2010) compared to 15 for emerging markets.

Frontier markets have a low correlation (0.54) to the Standard & Poor's 500 Index which improves a portfolio's diversification.  Compare this to emerging markets and small cap indices' correlation of 0.8.  The historical risk/return profile (standard deviation of returns) is attractive.  However, this may be the smoothing effect of having illiquid markets.

Some additional risks of frontier markets are operational (trade settlement), regulatory/market (capital flow restrictions and limits on foreign ownership), political and transaction costs (commissions, high spreads, taxes and less liquidity).

The report can be accessed here.