« frontier markets » : compelling and diverse long-term return opportunities

These frontier, or “pre-emerging”, markets have a relatively low correlation with global peers, offer high growth potential and, currently, attractively low valuations relative to mainstream emerging counterparts..

Russell Investments Analysis

Many established, raw material-rich emerging markets have become more correlated with developed markets as the access to natural resources has diminished in the latter. Frontier markets have, on the other hand, traditionally been fuelled by local demand, but the globalisation of trade is creating real and multi-dimensional growth across the broader emerging markets asset class.

These markets were until recently characterised by limited market accessibility, small company size and low liquidity. Those characteristics remain to some degree, but conditions have eased and markets have now become more investable, with lower restrictions on foreign investment and improved liquidity. Frontier markets have an untapped economic potential that we believe is very compelling as a long-term investment opportunity.

Combination of resource wealth and increasing macroeconomic/political stability are key draws for investors

Their populations are typically younger and growing more aspirational, with an ever greater access to information. This “demographic dividend” should herald a virtuous circle of increased demand and consumption, more employment and ultimately increased economic growth.

Moreover, those countries show an increasing macroeconomic/political stability and various resource wealth.

Finally, because of diversity, and low levels of foreign ownership, stocks tend not to move in line with developed and emerging peers, in fact, they even tend not to track one another. For example, Eastern European markets will typically trade in line with each other, and will perhaps be more in line with developed regional peers, but they will trade very differently from the African and Frontier Asian countries.

Key benefits of holding an allocation to frontier markets in a diverse portfolio

 Frontier markets have a lower correlation with developed markets.
 Potential source of higher alpha. Managers that have dedicated resources to fundamental research in these areas could have a significant informational advantage, particularly those that have lengthy experience investing in emerging markets.
 Broadening investment opportunities - Countries. Frontier markets broaden out the opportunity set of equity investing by offering access to countries in the earlier stages of market development. Strategically diversifying into these markets could help those investors looking for opportunities beyond core emerging countries.
 Broadening investment opportunities - Market-cap. Frontier markets companies tend to be smaller than their emerging peers.
 Frontier markets present new opportunities. The strength in frontier markets, the evolution of their capital structures and growing equity culture has increased the depth in stock markets, market liquidity, and the opportunity set for active stock selection processes.

Attractive new markets and valuations

The “early mover advantage” is, as its name suggests, transitory. Interest levels in these markets are growing rapidly, while high quality manager capacity is acutely limited. Meanwhile, valuations in these markets are currently very attractive relative to mainstream markets. The return opportunity will inevitably diminish over time, as markets develop and investor participation rises.

Investing Risks

Frontier market investments are typically perceived as being of higher risk than developed or emerging peers, given certain structural factors. These factors make frontier markets more vulnerable to sovereign, geopolitical, structural and inflation risks.
 Sovereign/geopolitical risk: Political systems are not always stable or fully democratic. Potential risk in rising protectionism and capital control.
 Structural risk: Returns can be more volatile and price movements more extreme. Markets can have differing levels of accessibility. The costs of investing are high and transparency is low. Frontier market indices often therefore list the most-liquid stocks in what are thinly-traded markets, meaning investors could hold concentrated positions in sectors or countries.
 Inflation risk