Some investors have found a potential opportunity for diversification beyond emerging markets: frontier markets. What differentiates these two classes of developing economies? Global index developer MSCI gauges a variety of criteria to distinguish between the two, including:
- Market capitalization of publicly traded companies
- Liquidity of publicly traded assets
- Accessibility for foreign investors
- Operational efficiencies and stability of the country’s investment market infrastructure
In general, frontier markets are smaller, less liquid, and less stable than emerging markets. That said, they have begun to draw the interest of traditional and impact investors alike.
What Are Frontier Markets?
The term “frontier market” is a moving target. While the MSCI Frontier Markets Index features stocks in 28 countries, the S&P Frontier BMI includes holdings from 33 countries. The shifting sands stem in part from the evolution of frontier market countries themselves, which can ascend to emerging market status as they grow, provide more opportunities for outside investors, and increasingly stabilize.
For example, Qatar, the United Arab Emirates, Pakistan, and Argentina have left the ranks of frontier markets within the past five years, according to Bloomberg. To replace them, index makers turn to less-developed countries, with risk reverting to levels inherent in less mature financial markets.
Somewhat counterintuitively, the Handbook of Frontier Markets explains that while these markets are more likely to face government instability or regulatory risk, they may also bring potential advantages, including modest volatility and low correlation with other markets.
Still, in October 2019, the International Monetary Fund cautioned that like much of the over-leveraged developed world, elevated borrowing levels among frontier market countries have raised debt sustainability concerns; it has pushed for “prudent sovereign-debt management practices and frameworks.”
Impact Investing in Frontier Markets
The economic, social, and environmental profiles of frontier markets may appeal to some impact investors targeting Sustainable Development Goals (SDGs), as a recent Global Impact Investing Network (GIIN) report suggests.
Of the 40 investments (managed by 24 investors) analyzed, over half were in sub-Saharan Africa, with another quarter in Latin America. Three-quarters targeted risk-adjusted market-rate returns, and the vast majority of all respondents reported returns that either exceeded or met their expectations (20% and 68%, respectively).
Results for impact goals were similar, with 90% of respondents saying that impact performance met or exceeded their expectations. The top three SDGs cited were decent work and economic growth (SDG 8), no poverty (SDG 1), and industry, innovation, and infrastructure (SDG 9). Accordingly, the report puts special emphasis on the potential for frontier market investments to spur long-term systemic change by “shaping and strengthening market infrastructure, access, and stability.”
Despite challenges including raising and deploying funds, country-level knowledge gaps, and high transaction and operating costs, the report highlights several success stories. For example, the Mercy Corps Social Venture Fund has deployed $1.6 million in equity and convertible debt to help companies deliver needed products and services, foster employment growth, and boost income and savings for low-income populations in Latin America, Southeast Asia, and sub-Saharan Africa.