With all of the talk about how frontier markets are growing so rapidly and returning investors very handsomely, it can be easy to forget about the negative side of these markets. When people hear that they can make a 159% return on their money in 12 months (as Sri Lanka is estimated to do according to Thompson Reuters: Frontier Markets), they tend to overlook the risks that must be taken in order to invest in such a country. This blog post is here to gently remind readers why frontier markets are not yet a standard investing destination yet, and why they are considered a step below emerging markets.
The first major downfall of frontier markets is that they are much more illiquid then developed economies. This means that there are much less buyers and sellers in the market, with as little as $50,000 of shares traded daily according to theglobalguru.com. With the lower amount of liquidity, you may be stuck with your investment in these markets well past the point you wanted to sell it at or you may not be able to buy what you want. Thompson Reuters has a great PDF on how to define liquidity and the risks of it in frontier markets. Another factor that ties in with illiquidity is that many of these markets do not have foreign currency markets that they can intervene in to help stabilize their economy.
Another huge risk with investing in frontier markets is that they are hotbeds of political upheaval and corruption. According to the Corruptions Perceptions Index (CPI) the least corrupt frontier market is the United Arab Emirates, which comes in as the 30th least corrupt country in the world. Most frontier markets fall in the middle of the pack when it comes to corruption according to the CPI. This means (and an article from the Wall Street Journal helps confirm this) that bribery is widespread and common in frontier markets. For foreign investors, the possible necessity to bribe is doubly bad. 1) The government of the country you are investing in may claim your assets if they discover corruption and 2) your home country may slap you with a fine as well. In just one natural gas project, the U.S. government has already given around $1.3 million in fines. As for political upheaval, if the society of the market is not stable, the odds are that the market will not be stable as well. With all of the political unrest and changes in these markets, they are more likely to receive drastic “market-making” news then their developed counterparts.
All of these factors play into what I feel is the greatest reason why frontier markets are risky: they are subject to much greater market swings. Put in another way, in a frontier market, the lows are lower and the highs are higher. A potential investor must be able to stick with their plans through these market adjustments. Otherwise, they may lose whatever return that they may have received from their investment. For a much more in-depth read on the risks of frontier markets, MSCI (the company that has produced the index that is considered the standard for defining what a frontier market is) has a PDF which details the risks of each frontier market on a country-by-country basis.
Despite all of these risks, frontier markets can still be a great place to invest. However, the investor must be educated and informed about the choices that they are making and the risks that they are taking on by doing so. They must also realize that it is by no means guaranteed for a frontier market to become an emerging market (and then a developed market). Frontier markets can stay at this classification level for years or may even lose their current frontier market classification. Frontier markets can be a place where investors earn huge money, if they’re willing to take the risks.