It’ll be a tough task so soon after the latest “Star Wars” theatrical release, but remember that other shoot-’em-up sci-fi epic? Not the one in a galaxy far, far away, but the one where space is the final frontier?
Humanity may not be as advanced as it is in “Star Trek” — yet — but there are still frontiers to explore, at least in investing.
Frontier markets, much like the Wild West, are places to seek wealth that are also notoriously risky. They’re even further out on the risk-reward continuum than emerging markets.
But for investors looking for potentially stronger growth and portfolio diversification, it could be a good idea to move a small portion of emerging market holdings into frontier markets.
Emerging versus frontier markets. There’s no hard-and-fast dividing line between emerging markets, such as Brazil, India, Russia and China and frontier markets such as Serbia, Kazakhstan and African nations, including Morocco and Nigeria.
But in general, emerging and frontier markets are distinguished by size, level of development and liquidity within their respective financial systems. Standard of living, progress of government institutions and infrastructure are also factors.
Emerging market economies tend to be larger, more developed and more liquid than frontier markets.
There are potential rewards … Emerging and frontier markets offer opportunities for growth and diversification, says Mike Cirami, co-director of global income for Boston-based Eaton Vance Investment Managers.
The overall gross domestic product growth rate from 2000 to 2014 was faster in frontier markets than emerging markets, but frontier markets have a low correlation with large-capitalization U.S. stocks, says David Waddell, CEO of investment firm Waddell & Associates in Memphis, Tennessee.
If institutional investors decided that frontier markets were more investable, there is room for a lot more money to flow into the space, Waddell says. He estimates there’s about $5 billion invested in frontier market funds, compared with $500 billion in emerging market funds.
Frontier and emerging markets also tend to be more inefficient than more developed markets, both experts say. That can allow investors to be more competitive than, say, in the vast and very liquid U.S. Treasury market, Cirami says. In emerging market investing, active management of funds can really add value, Waddell says.
… and plenty of risks. However, frontier markets can be plagued by corrupt politicians, lack of political stability and government confiscation of assets. “They’re ripe for waste, fraud, corruption and abuse,” Waddell says. “It’s not for the faint of heart.”
Illiquidity is another potential risk. If investors want to sell their stocks, they may not be able to readily find a buyer, he says.
Frontier markets are also highly volatile, meaning investors run the risk of buying high and selling low, Waddell says. So investors need to take the long view.
Active management is key. Waddell and Cirami steer investors away from frontier market exchange-traded funds. Because ETFs stick to whatever benchmark they’re priced against, investors can miss out on the diversity and scope offered by ever-changing frontier markets, Cirami says.
Waddell says purchasing shares of frontier market ETFs could prevent investors from taking full advantage of dispersion, which can lead to outsized returns from individual countries and certain companies within those nations.
And although large international companies have publicly traded subsidiaries in emerging markets, such as Nestle Nigeria and British American Tobacco Bangladesh, Waddell also cautions against trying to pick individual stocks.
That leaves investors to focus on actively managed mutual funds, which both experts say are the way to go when investing in frontier markets.
Actively managed funds provide managers with discretion to lower or eliminate exposure to potentially risky companies and countries as a wide variety of variables and financial conditions change.
They can also look for what Cirami calls “inflection points” in a country’s economic trajectory, such as South Africa’s loosening of its fiscal policy following a change in leadership that began prioritizing social issues over the economy.
For investors, a portfolio allocation strategy could include moving some money from emerging market ETFs into actively managed frontier market funds, Waddell says. With this strategy, an investor with 10 percent in emerging markets would end up with perhaps 7 percent in emerging markets and 3 percent in frontier markets, he says.
He recommends the Wasatch Frontier Emerging Small Countries Fund (ticker: WAFMX), HSBC Frontier Markets Fund (HSFIX) and the Morgan Stanley Frontier Emerging Markets Fund (FFD).
Frontier markets and the Fed. December’s Federal Reserve interest rate hike has drawn plenty of international interest from both emerging and frontier markets, especially among those who carry debt in U.S. dollars. Although Cirami says America’s slight uptick in rates was already priced into the emerging and frontier market space, it’s still unclear how many rate hikes the market will see in 2016 and how aggressive the Fed will be in normalizing policy.
A Fed that is more aggressive than expected would act as a headwind for emerging and frontier market assets unless the hikes are also accompanied by greater-than-expected growth in the U.S., he says.
Looser monetary policy tends to inflate asset prices, at least in the U.S., where the Fed had kept rates near zero since 2008 in the hopes of stimulating economic growth after the financial crisis.
Also, tighter monetary policy tends to be better for the U.S. dollar, which makes it more difficult for countries to pay back dollar-denominated debt. A stronger dollar also makes commodities less expensive. That would hit the coffers of the many frontier nations that are commodities exporters.
Looking for the bottom. In recent years, emerging and frontier markets have been under pressure as commodities prices have dropped, the Fed has become more hawkish and China’s growth and currency policy have become less certain, Cirami says.
While the asset class is probably near a bottom, he cautions that there may still be some room to drift lower.
In efforts to buy low, investors can either wait for a bounce and buy, or they can start allocating more money toward the asset class gradually at various intervals, he says.
More from U.S. News
12 of the Biggest Data Hacks of 2015
13 Stocks to Buy to Bet on China
16 Things Investors Should Know About Crowdfunding
Frontier Markets Offer Growth, Diversity to Investors originally appeared on usnews.com
