Frontier markets

A frontier market is a type of developing country which is more developed than the least developing countries, but too small, risky, or illiquid to be generally considered an emerging market. The term is an economic term which was coined by International Finance Corporation’s Farida Khambata in 1992. The term is commonly used[1] to describe the equity markets of the smaller and less accessible, but still "investable", countries of the developing world. The frontier, or pre-emerging equity markets are typically pursued by investors seeking high, long-run return potential as well as low correlations with other markets.[2] Some frontier market countries were emerging markets in the past, but have regressed to frontier status.[3][4]

Terminology

The term began use when the IFC Emerging Markets Database (EMDB), led by Farida Khambata, began publishing data on smaller markets in 1992. Khambata coined the term “Frontier Markets” for this set of indices. Standard and Poor's bought EMDB from IFC in 1999 and in October 2007, S&P launched the first investable index, the Select Frontier Index (30 of the largest companies from 11 countries) and the Extended Frontier Index (150 companies from 27 countries).[5] Subsequently, MSCI Barra began a rival frontier market index,[6] and in early 2008, Deutsche Bank launched the first frontier market exchange-traded fund, on the London Stock Exchange.[7] Frontier markets are a sub-set of emerging markets, which have market capitalizations that are small and/or low annual turnover and/or market restrictions unsuitable for inclusion in the larger EM indexes but nonetheless "demonstrate a relative openness to and accessibility for foreign investors" and are not under "extreme economic and political instability."[6]

Members could be considered to fall roughly into three groups:

Small countries of relatively high development level (such as Estonia) that are too small to be considered emerging markets,
Countries with investment restrictions that have begun to loosen as of the mid 2000s (such as the countries of the Gulf Cooperation Council)
Countries at a lower development level than the existing "mainstream" emerging markets (such as Kenya or Vietnam).[8]

The term pre-emerging markets is sometimes used as a synonym for "frontier markets", emphasizing the expectation that they will eventually "graduate" to "emerging market" status.[9]

Investor Marko Dimitrijevic defines frontier markets as primarily the “nine smaller members of the MSCI Emerging Markets Index (Colombia, Czech Republic, Egypt, Greece, Hungary, Peru, Philippines, Qatar, UAE)…” He suggests that many frontier markets are quite rich, but their reduced size, trading restrictions, or foreign ownership negate their inclusion in the MSCI indices.[10] Alternatively, Gavin Serkin asserts that the term indicates a country that has a per capita GDP that is lower than an emerging market, yielding less spending power. Characterized by little, if any, formal consumer industries as sector as most of the majority of transactions take place at street vendors. Alternatively, frontier markets can be closed to foreign direct investments and/or be too small for large investors to make substantial investments.[11] [12] The Financial Times lexicon offers an alternative definition, one that is adopted by economist David Mataen, as a market that has lower market capitalism and less liquidity than an emerging market. Their appeal to investors lays in their independence and potential for high returns.[13]

Investment case

Frontier markets have lower market capitalization and liquidity than the more developed, "traditional" emerging markets. The frontier equity markets are typically pursued by investors seeking high, long term returns and low correlations with other markets[14][15][16]

The implication of a country being labeled as Frontier is that, over time, the market will become more liquid and exhibit similar risk and return characteristics as the larger, more liquid developed emerging markets.

According to frontier market investors, frontier assets would actually diversify and reduce risk, which contradicts the general notion that risk would be added by including those markets.[17]

Those who have a focus on frontier markets have different views on what the future holds for the inter-correlation of countries within the asset class. While they share some economics characteristics such as young, increasing educated populations, the individual economies face different internal and external forces. Funds invest to find returns in countries that have increasing trends in domestic consumption but see the overall growth drivers for each country as being different.[18][19] This investment thesis holds water as it is unlikely that a manufacturing based economy, such as Bangladesh, would respond in the same way to external shocks as an island nation where a large proportion of the economy is linked to tourism, such as Sri Lanka.

There are also other non managed ways to gain exposure to these markets that are more generic such as investing in frontier market indices such as MSCI Frontier Index that only invest in large liquid stocks.