Must-know: Risks of investing in the frontier

Russ Koesterich, CFA - Author
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Aug. 18 2020, Updated 6:10 a.m. ET

However, while there is a strong case for embracing the frontier, it’s important to recognize that markets in the so-called “pre-emerging” world are not without significant risks. Not only do you have the same risks you’d have with any developed and emerging market, but there also are a number of risks specific to the frontier.

There is a higher risk of political turmoil in frontier market countries, of course. Plus given that frontier markets are at relatively early stages of development, particularly with respect to their financial markets, they offer limited liquidity. The high concentration of financial stocks in frontier markets also means that these markets could be hurt if there is a global banking sector downturn. Finally, frontier markets also could suffer if investors regain enthusiasm for emerging markets (VWO).

To be sure, given frontier markets’ strong showing in recent years, many investors are wondering whether they should still consider investing in the frontier, especially considering the risks mentioned above.

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My take: It’s certainly true that frontier markets have had a big run this year and they’re not without their risks, but their diversification benefits, lower volatility and growth potential warrant their inclusion as a long-term strategic holding in most portfolios, with one caveat. Given that the asset class is now closer to being fully valued, investors may want to use techniques like dollar cost averaging to slowly gain exposure to frontier stocks.

Market Realist – Investors can access frontier markets through primarily two good options—the iShares MSCI Frontier 100 Index Fund (FM) and the Guggenheim Frontier Markets ETF (FRN). Both these exchange-traded funds (or ETFs) are invested heavily in frontier markets’ financial services and energy stocks. The following graph shows returns from both these funds.

You need to exercise caution while investing in frontier markets due to problems of liquidity and high concentration in the finance sector. It would be most prudent to include them in a well balanced portfolio that consists of developed—as tracked by Vanguard FTSE developed market ETF (VEA)—and emerging market (EEM) equities. The iShares MSCI ACWI ETF (ACWI) tracks performance of all countries, both developed and emerging. As a result, it’s a good investment option. International exposure in the form of investment in emerging market equities (VWO) and frontier markets (FM) helps diversify a portfolio comprised of U.S. equities (SPY).

Diversification and asset allocation may not protect against market risk or loss of principal. International investing involves risks, including risks related to foreign currency, limited liquidity, less government regulation and the possibility of substantial volatility due to adverse political, economic or other developments. These risks often are heightened for investments in emerging/ developing markets or in concentrations of single countries. Frontier markets involve heightened risks related to the same factors and may be subject to a greater risk of loss than investments in more developed and emerging markets.

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