While much public discussion on emerging markets focuses on “mainstream” economies in Latin America and the Asia-Pacific regions, site investors are increasingly turning their attention to frontier economies. With a backdrop of historically low fixed income yields and considerable uncertainties in the trajectories of both Western and emerging market economies, frontier markets offer significant returns coupled with low correlation to other markets. These characteristics stem from a very early position in the economic growth cycle of countries, where many have experienced little or no economic progress in the recent past.

Classification as a frontier economy generally results from a country being too small to stand as an EM itself, having previously restricted international investment or having a lower development level then existing “mainstream” emerging markets. This produces a varied list of countries from oil-rich Gulf states, who are currently opening up for international investors, to severely under-developed sub-Saharan nations. Frontier markets are expected to grow in terms of capitalization and liquidity, making the jump into emerging market classification at some point in the future.

Since the start of January the Advance Frontier Markets Fund (AFMF), which generates exposure to countries including Pakistan, Vietnam, Saudi Arabia, Kenya, Nigeria, Peru and Bulgaria, has reported an 8.3% return compared to a 1% return for the BRICs and other established emerging markets. With little attention during the financial crisis period, managers such as AFMF’s Slim Feriani believe that “some of these markets are the cheapest they have ever been”. With high earnings growth and dividend yields, these markets are very attractive for long investors searching for decent growth potential and those who want relatively high pay-outs.

While befor

e the crisis Vietnam and the Gulf region were favoured, frontier market investors are taking larger positions on the African continent. The Financial Times recently reported that Nigerian stocks returned almost 63% in US dollar terms over the past year. However, while some economies offer large domestic returns, currency movements can significantly diminish the real return to international investors – which happened in Namibia where market growth of 8% translated into a 10% drop in US dollar terms.

Alongside a limited stock of investable companies and significant currency fluctuations, the main risk to African frontier investors remains political instability. In a fractious region well used to regular power struggles, an inward looking regime that restricts capital flows or poaches valuable real assets can evaporate an international investor’s position over night. Some argue that taking these risks into account, the African sub-Saharan region does not offer an appropriate risk-return profile.

Of course, what is generating these financial returns is an increase in economic activity. A key feature of any emerging market economy is the creation of a larger, wealthier and more consumer driven middle class. This can be quite a slow process in frontier markets, which are often only beginning to provide essential infrastructure such as reliable electricity supply. In tandem with an inflow of international financiers, the African continent is also experiencing a surge in activity from multinationals such as Diageo and Unilever who see potential rewards in the long run from this new economic activity. It remains to be seen how the future prospects of these frontier economies actually pan out, and how long investors and companies will have to wait before they can reap the benefits of the economic growth cycle.

-Eoin Callaghan