Understanding frontier market risks

US regulator warns investors that in spite of potential for higher returns, they should be aware of frontier market risks

The standard warning for all investments – whether they are made in developed, emerging or frontier markets – is the higher the risk, the higher the potential returns. It is typically what is referred to as the risk-adjusted rate of return. However the US regulatory body, the Financial Industry Regulatory Authority (FINRA) recently issued the bulletin, which cautions investors to carefully consider heightened frontier market risks – which are essentially emerging markets in the making.

“Investors seeking potentially higher returns in frontier funds should understand that the promise of higher returns always carries more risk—and the past performance of any fund is never a guarantee of future results,” said Gerri Walsh, FINRA’s senior vice president for investor education in a FINRA release. “Before investing in a frontier fund, investors should consider whether and how such an investment might fit as part of a well-diversified portfolio,” he added. This warning, though relevant, is typical of all investments.

FINRA advised investors to understand which countries a fund invests in; to be aware of the added geopolitical and currency risks; and, to pay close attention to fees and costs, which can be higher than other emerging market investment vehicles, and substantially higher than more conventional, diversified funds. It also stresses that, as frontier funds are relatively new, most of them have limited performance histories; and, it reminds investors that use index funds to pay attention to changes in the composition of indexes.

In its publication, Frontier Funds—Travel With Care, FINRA, provides investors with the following tips to avoid problems when considering to invest in frontier markets.

• Know which frontier markets the fund invests in. Risk factors vary by country—and no two countries share identical risk elements.
• Monitor changes in index components. If you are investing in a frontier ETF or index mutual fund, make sure you know and understand the index that the fund tracks and also the components of that index. The countries included in a frontier index can change over time.
• Geopolitical and currency risks are real. Be aware that some frontier markets are located in parts of the world with unstable political or market environments.
• Factor in costs and fees. Frontier fund costs and fees can be higher than their emerging market peers, and significantly higher than broadly diversified domestic and international managed funds.
• Consider Performance History. Frontier funds are relatively new, and most have limited performance histories.
• Learn as much as you can about the fund manager. Understanding frontier markets and managing investments is a specialized skill. Research the fund manager’s professional experience, including fund management tenure and performance record.

The index provider, MSCI currently list 35 frontier markets in Africa, Asia, Central and Eastern Europe, Latin America and the Caribbean and the Middle East. For the year-to-date period ending September 18, Bangladesh was the top performing frontier market on the MSCI Frontier Market Index with a gain of 48.71% in US$. The MSCI Frontier Market Index was up 18.54% in US$ for the same period.

Dwarka Lakhan

Dwarka Lakhan is a pioneer in emerging markets journalism in Canada. His first emerging markets article, “Africa Joins Ranks of the Emerging,” appeared in Investment Executive, Canada’s leading newspaper for financial advisors, in September 1994. Since then he has written hundreds of articles on the full spectrum of emerging markets and has conducted more than two thousand interviews with emerging and frontier markets investment professionals.

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