The Final Frontier For Investing

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INDIANAPOLIS -

Emerging Markets are old hat for investors. Are you ready to diversify into the least-developed, but fastest-growing countries that make up the Frontier Markets? Just like a "Star Trek" adventure, it comes with bold challenges.

"Space: the final frontier. These are the voyages of the starship Enterprise. Its five-year mission: to explore strange new world; to seek out new life and new civilizations; to boldly go where no man has gone before." This quote comes from the popular 1960's TV series, Star Trek. Just as space was the final frontier in Star Trek, the frontier markets are the last uncharted area for investors.

With developed markets fully explored and emerging markets reaching mainstream now, investors may want to consider looking to frontier markets. Before you decide to invest, you need to understand the characteristics of a frontier market economy and most importantly, the risks.

What are Frontier Markets?

The definition of frontier markets is somewhat subjective as there is no set or common definition. The countries are typically at an earlier stage of development relative to developed and emerging market countries and are experiencing a period of rapid growth.

The best way to describe frontier markets is to draw a parallel to human development. If a developed market is a mature adult and an emerging market is a teenager, then a frontier market is a young child that is learning very quickly. Just like a child, this is the phase when economies are experiencing fast growth, often times faster than the teenager’s. The growth is typically driven by an increase in capital inflow from foreign investment as well as the beginning of liberalization and stabilization of government and business policies.

As mentioned earlier, these countries are like children moving rapidly towards their teenager years. Raising a child can be very rewarding, but it comes with challenges. Just like the child, frontier markets are still shaping and developing the infrastructure of their securities markets. Additionally, not all frontier markets are created equally. The contrasts in characteristics are vast. It ranges from extremely wealthy Middle Eastern economies to less developed, but rapidly growing, African countries.

Why Invest in Frontier Markets?

Growth Potential. One of the main reasons to invest in frontier markets is to cash in on their rapid growth. Frontier markets are small, about 10 percent of GDP, but big in terms of population. They have young populations with 70 percent below the age of 40. This translates to strong consumption potential in the next ten to fifteen years. It is estimated that frontier economies will represent more than one third of the world's population by 2050. The largest expected middle class growth opportunity will be across the African continent.

Diversification. Frontier markets also provide attractive diversification benefits with low correlations to other equity markets. We have all heard the phrase "Don't put all your eggs in one basket." Generally, diversification protects your investment portfolio from being vulnerable to the ups and downs of any one specific investment category or region. Given that correlations between the developed world and the emerging markets have steadily increased, investors may want to consider frontier markets for diversification purposes.

The Risks

Investing in these hot economies does come with higher risks as frontier markets on a country level are a very risky asset class. Issues that plague many emerging markets are generally intensified in many frontier markets. The political instability of many frontier markets causes the countries to be more volatile.

Currency fluctuation is another concern of investing in small and developing countries. Currency hedging is often either prohibitively expensive or simply not available. Transparency and corporate governance are more likely than not to be absent in frontier markets. Finally, many frontier countries lack liquidity as often they make only a fraction of their shares available to foreigner investors, while others impose capital controls, which prevent ease of investor flows.

Summary

Frontier markets have attracted increasing attention in recent years. The main reasons to invest are new opportunities for diversification and significantly higher returns. These booming markets typically have higher growth prospects, but a greater variety of risks, than emerging and developed markets. While these risks are very real, they are very typical signs of the early development stage of the asset class. The challenge for investors is to find ways to cash in on the growth without taking on an unreasonable amount of risk.

Anthony Bykovsky, CFA, an Associate Portfolio Manager at Bedel Financial Consulting, contributed to this article.

Elaine E. Bedel, CFP, is CEO and president of Bedel Financial Consulting, Inc., a wealth management firm located in Indianapolis. She is a featured guest each Wednesday on the WTHR (NBC, Indianapolis) Channel 13 News at Noon, "Your Money" segment. Elaine's book, "Advice You Never Asked For... But wished you had," is available on Amazon.com. For more information, visit www.BedelFinancial.com or email Elaine at ebedel@bedelfinancial.com.