“Exploring the unknown requires tolerating uncertainty.”
~Brian Greene, American Theoretical Physicist
When the Federal Reserve drastically scaled back its quantitative easing program earlier this year it sent shock waves throughout the emerging markets. During the last few years, artificially low interest rates in the US and other developed markets (a result of quantitative easing such as the Fed’s bond purchasing program) led to vast amounts of capital flowing into emerging markets where investors could get better returns. With the Fed reducing its bond purchases, capital started fleeing emerging markets and resulted in these economies facing higher borrowing costs, currency depreciation and stock market declines.
As a result, many global investors started searching for the next BRIC and frontier markets are getting a lot of attention. Relatively ‘unknown’, frontier markets are often less developed than emerging markets and typically offer returns that are uncorrelated to the wider global economy. MSCI, a provider of investment decision support tools, categorizes over 30 countries as frontier markets and includes 26 of these in the MSCI Frontier Markets Index. Although frontier markets have performed very well in recent years, there were always questions in the minds of investors about how diversified their exposure to frontier markets was since three countries - Kuwait, Qatar and the United Arab Emirates (UAE) - comprised over 50% of MSCI Frontier Markets Index. This issue has been put to rest with the official promotion of Qatar and the UAE to ‘emerging market’ status on June 2, 2014. Now that these two very rich countries have departed the Frontier Markets Index, investors trading ‘global frontiers’ will have more exposure to the growth potential of countries in Asia, Africa and Latin America along with better diversification. The index also now provides a more accurate representation of trading and investing in frontier markets.
Investing in frontier markets, of course, carries a lot more risk than emerging markets. These markets bear geopolitical risk and are small, volatile, highly illiquid and rather opaque. Successfully trading frontiers requires partnering with firms that not only have a local presence in these markets but also deep knowledge of local business culture, laws and regulations. As these markets become more attractive more global investors, the firms that succeed in seizing opportunities and unearthing alpha will be those that effectively invest in trading infrastructure and technologies. This would include investments communications and networking.
Global investors genuinely want exposure to countries that will be changing rapidly in the next few years and offering new sources of growth. With emerging markets turning bearish, the smart money (despite the accompanying risk and volatility) is going to frontier markets.