Investors face a significant challenge of finding growth in a slow-growth world. In the short term, they face a world where most of the major asset classes appear fully valued, and in some cases downright expensive. Over the longer term, many developed countries face significant difficulties, including high levels of debt, political dysfunction, aging populations and other demographic challenges, all of which seem to portend slower growth going forward. Similarly, many emerging markets have stalled in taking necessary steps toward reform, but they are also showing increasing correlation with their developed market counterparts. Developed markets (DM) and emerging markets (EM) are essential building blocks of a portfolio, but investors seeking greater potential growth and diversification benefits need to look elsewhere.
Enter frontier markets, sometimes referred to as “pre-emerging markets.” Although they can vary individually by a considerable amount, frontier markets share certain traits: They are at relatively early stages of development, particularly with respect to their financial markets. They offer significant growth potential, often at least partly a result of quickly growing, young populations. And for investors, in addition to the potential for higher returns, they offer diversification benefits; surprisingly, they have a fairly low correlation to developed and emerging market returns.
But investing in frontier markets comes with risks. There is a risk of political turmoil, of course. They also offer limited liquidity, and given the high concentration of financial stocks in frontier markets, they would be imperiled if there is a global banking sector downturn. They also could suffer if investors regained enthusiasm for emerging markets.
This paper discusses the risks and rewards inherent in frontier market investing. While investors should be fully aware of the risks, we do believe the growth potential and diversification benefits warrant their inclusion in most strategic asset allocations.