Must-know: Frontier and emerging markets investment pros and cons

Market Realist

Overview: Investing in emerging and frontier markets (Part 5 of 6)

(Continued from Part 4)

The pros and cons of investing in frontier and emerging markets

While frontier market investments certainly come with some substantial risks, they also post very high returns. The frontier market contains anywhere from one-fifth to one-third of the world’s population and includes several exponentially growing economies. According to the January, 2014, release of the KPMG high growth markets magazine, Africa hosts six of the world’s top ten fastest growing economies. Southeast Asia’s ASEAN Economic Community (or AEC) is on the path of creating a new free-trade zone consisting of ten countries and over 600 million people. Latin America is making strides with Chile recording faster-than-average growth and infrastructure spends around 5% of its gross domestic product (or GDP), while other Latin American nations like Brazil, Peru, and Mexico, are pushing for privatization through public-private-partnerships (or PPP).

The Pros

In the earlier sections of this series, we have discussed the benefits of investing in the frontier market. These include:

  • The potential diversification benefit
  • Faster growth
  • Lower volatility

Emerging markets as an attractive investment destination

Emerging markets are quickly becoming the driver of global growth. According to the International Monetary Fund (or IMF), 70% of world growth over the next few years will come from emerging markets, with China and India accounting for 40% of that growth. Besides the well-known benefits of high returns, faster growth, and diversification, here’s what makes them so attractive:

  • Countries such as China and Russia sport a stronger balance of payments positions than advanced economies.
  • India and Brazil have high ratios of working-age to retired populations. A younger working age population is a definite growth driver.
  • Companies in the emerging markets are getting bigger and commanding an increasing percentage in the world market capitalization.
  • Interestingly, the disproportional share of natural resource wealth among the emerging market economies acts as a mutual growth driver. Iron ore rich Brazil has been benefiting from the rising demand that resulted from the rapid industrialization in China. Brazil’s mining company, Vale (VALE), is the world’s largest iron ore exporter and China has been its biggest buyer. More investors are trading Vale shares daily on the New York Stock Exchange (or NYSE) than are trading Chevron (CVX) or IBM (IBM). Although the rate of China’s industrialization may have slowed down recently, Brazil is also ready as the world’s leading sugar, coffee, beef, and chicken exporter.

It’s due to the above factors that exchange-traded funds (or ETFs) like the iShares MSCI Frontier 100 ETF (FM) and the iShares MSCI Emerging Markets (EEM) have gained popularity in the ETF space.

The cons

While the returns may be attractive, there are certain key risks that entail investments in frontier and emerging market economies. The key risks associated with investing in these markets are:

  • Liquidity risk because these markets are smaller and less liquid than the developed markets
  • Concentration risk because most emerging and frontier market funds are concentrated among just several countries and fewer industries with a few stock holdings each
  • Geo-political risk, which is usually very high in these countries

Although most of these risks remain common for both markets, their degree may vary. For example, frontier markets comprise a very small slice of the global economy with approximately 2% of global market capitalization. As a result, the liquidity risk for frontier markets is far greater than that for emerging markets. Along with the key risks mentioned above, both of these markets may also carry investment risks like market, sovereign, and currency risk, as well as the risk of nationalization.

The next section in this series gives insight into investment options available for investors seeking exposure to emerging or frontier markets.

Continue to Part 6

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