Invest in the BRIC countries? Sure. Many if not most financial planners devote some client assets to stocks from Brazil, Russia, India and China, which have propelled emerging-markets funds to spectacular returns over the last decade.
But what about investing in the next layer of BRICs-which might include stocks from Bangladesh, Romania, Ivory Coast and Cambodia? These frontier markets might develop into tomorrow's emerging economies. Or sink into oblivion.
"There are definitely opportunities for appreciation in these areas, but there is also a major downside with the political uncertainty," says Andrew Feldman, a financial planner in Chicago. "Some of my clients are exposed to the frontier markets, as a subset of emerging markets, but these funds are extremely volatile and not appropriate for smaller accounts."
FINDING THE FRONTIER
Proponents of frontier markets believe they're attractive for many of the same reasons used to support allocations to emerging markets. Economic growth might be far higher, for many years, than the growth rates in the United States and developed foreign markets. Within frontier markets, an expanding middle class may bolster a desire for an improved lifestyle, thus generating profits for local businesses. Many frontier markets are rich in natural resources and likely to profit as demand increases.
Planners who believe frontier markets may be the next hot asset class face some obstacles in getting exposure. For one, explaining frontier markets is not so easy.
Obviously, a frontier market is one not in the "developed" or "emerging" categories. Many countries fit that description, but some are poor choices for investors. Potential picks should include a lineup of publicly traded companies, liquidity reporting requirements, property rights, rule of law and other features investors expect to find in a country serious about attracting international investment.
"They tend to be more rural and low-tech, yet market-oriented, with high human capital. Frontier markets are forecast to have twice the economic growth rate of emerging markets in the next three to five years," says Christian Hviid, chief market strategist at Genworth Financial Asset Management in Encino, Calif.
Moreover, investors are not paying much for that growth because of the risks. "Access to information about those markets is improving, but it is still a challenge," Hviid adds. "The worldwide market cap of frontier markets is less than their worldwide purchasing power, so their stock markets should outperform in the coming years."
Frontier markets may be ill-suited to investors if their time horizons are on the short side, however. "The growth occurring in the frontier markets will bring an opportunity for outsize investment returns for patient, long-term investors," says Mark Luschini, chief investment strategist at Janney Montgomery Scott in Philadelphia. "However, the process will not be linear, so investors should expect setbacks along the way."
Such setbacks have been apparent in 2011. The Middle East and North Africa play a huge role in frontier markets investing, and that region has literally come under fire in recent months. Stock markets in two frontier markets-Egypt and Bahrain-have faced shutdowns.
Under normal conditions, Luschini says his firm would suggest splitting an international allocation evenly between developed and emerging markets, and they might allocate one-quarter of the emerging markets weighting to frontier markets. Thus, about one-eighth of a client's international equity exposure could be in frontier markets.
His firm has reduced its emerging-markets recommendation to 25% or less of international exposure. He adds that, for now, they are reluctant to recommend any weighting in frontier markets, given the turmoil and uncertainty in the Middle East and North Africa.
"We are very cautious in the near term because of food inflation, which is causing equity market disruptions, and because of the political instability in some areas," he says. "One day's events can bring a rush of buyers to these markets followed by a riot, bombing or other shock that can cause declines of 5% to 10% in a single day."
That is uninviting from an investment perspective, he adds. "We think it is prudent to let the situation in the Middle East reach some resolution before committing capital unless the speculation of such an investment is understood and accepted."
Some advisors see a possible bright side. Feldman agrees the current crises can have a negative effect, but if there are favorable outcomes in some markets, the region's stability and growth might improve. "These are high-risk, high-reward allocations," he says.
Brent Brodeski, managing director of Savant Capital Management in Rockford, Ill., adds that the upheaval underscores a crucial theme-diversification. "If you hold many different frontier markets, several might get pummeled by political uncertainty while others do well. Thus, it is of paramount importance not to put too much in any given frontier country. While diversification is always important, it is even more so in frontier markets."
Although frontier markets and indexes to track these markets are relatively new, the risks and rewards can be seen in recent performance. The MSCI Frontier Market Index, launched in late 2007, suffered heavily in the 2008 worldwide crash. That index returned only 7% in 2009, far below the returns from developed and emerging markets. Yet frontier markets led the way in 2010, when the MSCI index returned nearly 19%.
Given the risks and potential rewards, how much might planners allocate to frontier markets? Hviid asserts that people generally are underinvested in emerging markets, but they are even more underinvested in frontier markets. "By market cap," he says, "an equity allocation might hold 14% in emerging markets and 1% in frontier markets. I think 18% and 2%, respectively, may be a reasonable allocation now, given the growth prospects."
Even a 1% allocation to frontier markets might be more than many planners are ready for. In many of Feldman's asset allocation models, emerging markets account for about 8% of equity holdings. He may use 5% to 10% of this amount for frontier markets. A $1 million portfolio that's 60% equities, for example, might have an allocation of around $48,000 (8% of $600,000) to emerging markets. That would make the frontier markets allocation range from $2,400 to $4,800 in the $1 million portfolio, shy of 1%.
Sheila Chesney, a planner in Sheldon, S.C., moved her clients into frontier markets in 2010, excited by the lack of correlation with both developed and emerging markets. "I started with a 1% allocation," she says, contrasting that to her firm's 3% minimum allocation to emerging markets. "When our allocation to emerging markets exceeds 3%, we carve off some of the excess and add it to frontier markets."
FINDING A FUND
Whether an allocation to frontier markets is 1% or larger, advisors have a few frontier markets funds to consider. Some planners might choose to participate via an index fund, but careful research is vital because frontier market indexes vary greatly.
The S&P Frontier Broad Market Index, for example, includes nine countries not in the MSCI Frontier Index. Colombia (which has one of the largest weights in the S&P Frontier Index) is in the MSCI Emerging Markets Index, while the other eight S&P Frontier countries, ranging from Cyprus to Jamaica to Zambia, don't appear in either MSCI Index.
Although such differences might seem trivial, a fund's decision on which frontier markets to include can make a difference in returns. For instance, the Forward Frontier MarketStrat Investor Fund states that its goal is to approximate the country and industry allocations of the MSCI Frontier Markets Index. In practice, this mutual fund keeps most of its assets in bond funds while using warrants, swaps and ETFs to gain exposure to Persian Gulf markets, Kazakhstan, Argentina, Lebanon, Nigeria, Kenya, Sri Lanka and Pakistan. In 2009, the fund returned only 3%.
That same year, Guggenheim Frontier Markets ETF (formerly the Claymore/BNY Mellon Frontier Markets ETF) posted a 54% return. This ETF, which tracks the Bank of New York Mellon New Frontier Index, recently held half of its assets in stocks from Chile, Egypt and Peru, which are considered emerging markets by MSCI and S&P. Many might think of these countries as frontier markets, but such a fund is likely to behave much differently from a fund focusing on Kazakhstan, Lebanon, Nigeria and Sri Lanka.
Feldman, who uses Guggenheim Frontier Markets for exposure to this asset class, contends that there is a "gray area" in the definitions of emerging and frontier markets. "Some emerging markets are much more developed than a country like Egypt or the Czech Republic," he says. "The Guggenheim Frontier ETF is definitely a straddle fund between emerging and frontier markets, but it gives a client some exposure to other countries. In the iShares emerging markets ETF, for instance, there is little or no exposure to Chile or Egypt."
In addition to frontier markets index funds, there are some actively managed entries. When Chesney's firm added an allocation to frontier markets to its portfolio last year, they decided to use Templeton Frontier Markets Fund. "I like the fund family," she says. Chesney also has been speaking with the people at the Nile Pan Africa Fund, but it doesn't have enough of a track record yet for her firm to wade in. While there are few broad frontier markets funds, there are several regional funds, primarily covering the Middle East and North Africa, as well as single-country funds for frontier markets such as Egypt and Vietnam.
Yet another approach is to participate in frontier markets without investing in a frontier markets fund. Brodeski uses Eaton Vance Parametric Tax Managed Emerging Market Fund to gain diversified exposure to both emerging markets (about 80% of assets) and frontier markets (20%). His firm started using this fund, which captures passive and structured exposure to those asset classes, more than 10 years ago.
It's been a top-performing fund, returning nearly 20% a year for the past 10 years. The fund recently listed stocks from the more familiar emerging markets as well as holdings in frontier markets such as Botswana, Croatia, Ghana, Kuwait and the United Arab Emirates.
No matter how they invest, planners should emphasize that frontier market holdings can be even more volatile than emerging markets. "Our firm has been investing in emerging markets since 1993, when many of the countries that we now consider emerging or emerged were probably truly frontier markets," says Cheryl Holland, president of Abacus Planning Group in Columbia, S.C. "However, we are just now doing our homework on the new frontier markets and don't have any specific investments there."
Holland recalls that 1993 and 1998 were troubled years for emerging markets. "That was one of my first lessons," she says. "Getting in too early may kill off the long-term benefits of being right. I could have done better educating clients about the rationale for that investment."
Planners considering an allocation to frontier markets might learn from Holland's experience. "If we were to recommend frontier markets, we would have good reasons for doing so and a detailed explanation of the risks," she says. "My sense is that 99% of our clients would be comfortable with any suggestion we made if we educated them on the process for selecting the investment and why we were making the recommendation as long as we were direct about the risks."