Characteristics & Risks of Frontier Investing
Frontier markets carry unique political and economic risk. In addition to their small economies, the lack a stable middle class and can experience destabilizing political turmoil. These markets are characteristic of lack of established legal, political, and capital structures which argues for active portfolio management skills. However, many of these risks are priced into to overall equity valuations which are low and dividend yields are higher than most asset classes.
Characteristics
  • The frontier equity markets are typically pursued by investors seeking high, long term returns and low correlations with other markets.
  • An availability of a growing low cost labor pool, increasing literacy rates, and rising standards of the middle class can outweigh the structural impediments inherent in many of these economies.
  • Many frontier markets are undervalued but are rich in untapped natural resources and commodities available at much lower extraction costs compared to developed economies.
  • Sector and stock concentration in many less liquid developing capital markets adds a level or risk that may need to be actively managed.
  • Very few investment vehicles are offered for foreign investors for broader access to Frontier Asian Markets.
  • Currency controls and restriction on foreign direct investment have to be considered in many small frontier markets.
  • Frontier equity markets exhibit low cross-correlations between themselves in a particular region thus providing additional diversification and lowers overall portfolio volatility.
  • Frontier economies are generally more dependent on indigenous demand for goods and services and less exposed to global economic developments than emerging market.
Risks
  • Frontier capital markets are less developed and stocks are more thinly traded, resulting in potentially higher trading costs and lower liquidity.
  • Lower turnover and less liquidity could result in a higher std. deviation of both individual and index returns relative to more developed markets.
  • Macroeconomic shocks to a particular economy or region may significantly affect the performance of frontier market stocks.
  • Currency, political and social stability, regulation, and lack of transparency are new “factors” for frontier managers to incorporate in their macro models.
  • Sector and individual security concentration is more pronounced and need to be managed. For example, bank stocks in many of the frontier markets can comprise up to 30% of the total market capitalization.
  • Idiosyncratic political and economic risk can result in severe single market volatility that can be somewhat mitigate with an active investment approach.
  • Broad corruption in the governments and private sectors coupled with weak judicial systems remain structural risks imbedded in all Frontier markets.