The Difference Between Emerging And Frontier Markets

Every investor knows to buy low and sell high. But those who seek substantial returns on their capital may have to wait for months or years to see their money grow exponentially if they invest in blue chip stocks such as Microsoft or Apple. Aggressive investors therefore frequently turn to the stocks of smaller companies that trade in less-developed markets in an effort to reap large capital gains. These companies are often found in the frontier and emerging markets. But the types of companies that trade in these two markets are not always alike.

Emerging Markets

Companies considered to be trading in the emerging market are usually located in what used to be referred to as “less economically developed countries" (LEDCs). These are countries that do not have the economic strength of nations like the United States or Japan, but are in the process of establishing a more mature marketplace. This sector of the global market contains greater risk along with the potential for greater rewards.

Frontier Markets

There is no universal definition of what constitutes the frontier market, but it essentially consists of companies and investments in nations that are economically even less developed than emerging market countries, many of which don’t have their own stock exchange. As of September 2013, Morgan Stanley has a list of 28 nations that it classifies in this market, including Croatia, Tunisia, Pakistan and Kenya. Frontier markets are categorically the riskiest markets in the world in which to invest. They have the least number of investors and investment holdings and may not even have a stock market on which to trade. Most frontier markets consist chiefly of stocks of financial, telecommunications and consumer companies that can count on monthly payments from customers. Investment holdings in this sector are typically illiquid, nontransparent and subject to very low regulation levels as well as high transaction fees. They may also contain substantial political and currency risk, and are thus inappropriate for novice investors in most cases. Caveat emptor applies to those who choose to explore this sector.

A Slow Shift in Development

Although frontier and emerging markets both fall into the same general sector of the global marketplace, there are some critical differences between the two subsectors. Emerging markets offer greater liquidity and stability than frontier markets. But as time progresses, many financial analysts believe some emerging markets have matured to the point where they are moving at least somewhat in tandem with the U.S. market and fail to provide the level of diversification that they once did. Frontier markets have slowly but surely started to step in and fill this gap for long-term investors seeking a return on their capital that is largely uncorrelated with the rest of the global economy.

Advantages and Disadvantages of These Markets

While frontier market investments certainly come with some substantial risks, they also may post the kind of returns that emerging markets did during the 1990s and early 2000s. The frontier market contains anywhere from one-fifth to one-third of the world’s population and includes several exponentially growing economies. However, frontier markets comprise approximately 2% of global market capitalization and thus remain a very small slice of the global economy. Some economists also believe that the frontier market companies in Africa (which equates to the majority of nations on that continent) will experience the next major world economic boom in the same manner as the U.S. and Pacific Rim countries such as Japan. The chief global economist at Renaissance Capital believes that Africa’s sub-Saharan economy will grow almost 15-fold over the next 35 years, from $2 trillion to $29 trillion. However, emerging markets can still provide higher returns on capital with less risk and greater liquidity than frontier market holdings, despite their increasing correlation with the U.S. market. Aggressive investors could profit in the long run with a dual allocation into each of these sectors.

How Investors Can Access These Markets

Several ETFs and mutual funds invest in emerging markets, and a small number of ETFs focus on frontier markets. Blackrock Capital offers the iShares MSCI Emerging Markets Index (NYSE:EEM), which posted average annual growth of nearly 14% from 2002 to 2012. It also recently launched the Frontier Markets 100 (NYSE:FM), which has grown exponentially in value since its inception. Guggenheim offers a broad-based ETF that covers virtually all countries that could be classified in the frontier market (NYSE:FRN). Powershares offers several ETFs that focus on specific segments of the frontier markets, such as the MENA Frontier Countries Portfolio (Nasdaq:PMNA), which concentrates on the Middle Eastern and North African regions.

Other ETFs invest in the stock exchanges of individual countries, like the iShares MSCI Mexico Investable Market Index Fund (NYSE:EWW). These securities can be analyzed in the same fashion as any other investment offering, but investors should thoroughly research the types of risks they would take with these instruments and be willing to commit their money for long time periods in most cases. Frontier and emerging markets may not always move in tandem with each other, depending upon global economic circumstances. Investors who seek broad diversification and less risk would probably be wise to divide the aggressive portion of their portfolios between the two subsectors.

The Bottom Line

Emerging and frontier markets both offer the prospect of higher returns with higher risk, but the former market is more stable and developed than the latter. The economies of emerging market countries have achieved a rudimentary level of development, while frontier markets represent the least economically developed nations in the global marketplace. However, this lack of development provides a level of investment diversification that cannot be duplicated in more mature markets. Both types of markets also carry several types of investment risk, including market, political and currency risk, as well as the risk of nationalization. For more information on these two subsectors of the global economy, consult your financial or investment advisor.

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