Frontier market according to Farida Khambata, head of the IFC’s capital-markets department in 1996, is a category of "developing country's market economy" which is more developed than a least developed country's, but too small, risky, or illiquid to be classified as an emerging market economy (Ty McCormick, 2013).
Why are frontier markets becoming more and more relevant?
International investors seek markets that promise higher returns and more efficient diversification.
However, looking at Uludag et al. work, increasing linkages and interdependence among global equity markets have made diversification opportunities more difficult to uncover. Back in the time, good diversification alongside high returns was provided by the emerging markets, but today such benefits have significantly diminished as emerging markets have evolved into developed and advanced emerging markets. So, frontier markets are currently attracting the attention of international investors, taking the place of emerging markets as a potential location for achieving the elusive aim of greater diversification with larger returns.
Classification of a country as a frontier market
Morgan Stanley Capital International (MSCI) states that when evaluating a country for inclusion in its Frontier Markets Index starts by considering all stock markets not included in its MSCI Emerging Markets Index, which are relatively open and accessible to foreign investors. Then checks if the country is not considered part of the developed markets universe and if it is facing a period of extreme economic, like hyperinflation, or political instability, like a civil war. After this verifies if the country has at least two companies eligible for inclusion in its index.
Frontier equity market
The term “frontier market” is often used to describe the equity markets of the smaller and less accessible, but still "investable" countries of the developing world. They are at the outermost limit of the acceptable investment horizon, beyond which markets are no longer suitable for investment (Uludag et al.).
Investing in the frontier market
So, as said before, frontier markets are small, risky, or illiquid, but according to Marshall et al. work frontier markets, are gaining importance, because even if they have high transaction costs, they can potentially lead to high, long-run returns and are low correlated with other markets.
So, the promise of great profits and growth potential make frontier markets more attractive to international investors.
As previously stated, there is little association between frontier market stock returns, and developed and emerging market stock returns. However, it is crucial to keep in mind that frontier markets have relatively high transaction costs that can affect the diversification benefits that international investors in these markets can receive.
Evidence on investing in the frontier market
A lot of studies have been produced on this topic, but results are not always unambiguous, results are strictly related to the main investigation focus of the studies:
- In their work, Uludag et al., making a resume of many other authors' works, argue that frontier markets have a high potential for diversification since they are less correlated with world markets and have a lower level of integration and interdependence with other market groups.
- On the other hand, Samarakoon (2011) suggests that frontier markets may not be the best alternative for diversification during a crisis period, and as argument cites that although frontier markets have very low correlations with the US market, during the subprime financial crisis the correlations of frontier markets in around the world increased more than the correlations of emerging markets.
- Focusing on transaction costs, as Marshall et al. did, it’s shown that while emerging markets appear to provide diversification benefits, sometimes these disappear once transaction costs are considered. Furthermore, Marshall et al. state, it seems that the diversification benefits of frontier markets prevail in the presence of short sales constraints, and transaction costs if investors re-balance every three months or longer, and this benefit is stronger in periods of low transaction costs. On the other hand frequent rebalancing, like every month or two, lead to an offset of the diversification because of the high transaction costs.
Frontier market and sustainability
When examining the studies by Odell et al., we must keep into account that the nations that are typically referred to as "frontier markets" typically confront numerous difficulties. Therefore, investing in this market today implies overcoming greater obstacles. According to Odell, investing in emerging and frontier markets must place an even higher emphasis on sustainability standards than doing in developed markets.
So, in conclusion, Odell et al. study makes it clear that emerging and frontier markets offer long-term investors exciting opportunities, but businesses operating in these markets must deal with a variety of environmental, social, and governance-related problems, such as:
- and corruption.
Odell believes that only by managing also these social and environmental challenges in these markets investors can achieve superior financial performance over time. They can grow faster, achieve higher profitability, reduce their cost of capital, and manage exogenous risks better than the other investors.
- Marshall B., Nguyen N., Visaltanachoti N. (2015). Frontier market transaction costs and diversification. School of Economics and Finance, Massey University, Private Bag 11-222.
- McCormick T. (2013). Frontier Markets: A Short History. How second-generation emerging markets became today's hottest investment story. Foreign Policy.
- MSCI Global Investable Market Indices Methodology. Morgan Stanley Capital International, (2011).
- Odell J. and Ali U. (2016). ESG Investing in Emerging and Frontier Markets. Journal Of Applied Corporate Finance, Vol. 28, No. 2, 96-101.
- Samarakoon L. (2011). Stock market interdependence, contagion, and the U.S. financial crisis: the case of emerging and frontier markets. J. Int. Financ. Mark. Inst. Money 21 (5), 724–742.
- Uludag B., Ezzat H. (2016). Chapter 5 - Are Frontier Markets Worth the Risk?. Handbook of Frontier Markets. Academic Press, 67-80.
Author: Paolo Baruffi