Are frontier markets the emerging markets of tomorrow?

Frontier market investing involves countries where information about firms and industries is opaque and incomplete, or where the infrastructure for trading securities is in an embryonic stage

Frontier. Say the word and we conjure up images of the American west in the early 1800s or a daunting field of study such as exo-meteorology (climate research on planets like Mars). Frontier suggests something to explore —an against-the-odds challenge that involves chilling risk and exhilarating discovery.

It’s no different in the hinterlands of investing. Frontier market investing involves countries where information about firms and industries is opaque and incomplete, or where the infrastructure for trading securities is in an embryonic stage.

But with these risks and challenges come the potential for growth and economic gain that, in some cases and during some periods, can be substantially better compared to other markets. One obstacle, however, involves the difficulty of trading frontier currencies. Trading currencies is necessary because if an investor buys a Kenyan stock, for example, the investor must pay for it in Kenyan shillings. When selling the stock, the investor will likely want to convert shillings to the investor’s domestic currency.

One key problem is that frontier currency markets are often classified as restricted because those currencies often are not readily traded like the euro, yen or Canadian dollar. Such restrictions can mean rigid controls on the institutions allowed to trade that nation’s currency. Or the trading process itself can involve a prohibitive level of paperwork in order to complete a currency transaction.

Because of these restrictions, the supply of frontier market currencies can be low, resulting in high costs and limitations in the number and size of transactions. The difference between buying and selling prices also can be punitive for investors – a spread of several percent. Compare that to the euro, where the spread between purchase and sale can be 1/100th of a percent.

But conditions on the frontier change, and sometimes quickly. Just look at what’s happened to some of the countries that used to have strict currency controls. Trading in the Southeast Asian markets of South Korea, Malaysia and Indonesia was once prohibited but is now permitted. As these countries continue to develop economically, currency trading will likely become less or even completely unencumbered.

So how might investors consider approaching these frontiers? In most cases, patience and realism are essential. Investors should be realistic about the risks and patient when it comes to returns. Difficulties in trading are an inescapable reality, at least for now. Frequent trading is likely to be too expensive, so most potential frontier investors have to approach these markets with a medium- to long-term investment horizon. But frontier markets are not entirely out of bounds for some stalwart investors.

Frontier markets are the start-ups of the global capital marketplace. If they prosper and stabilize, they are likely to evolve into emerging markets, perhaps even developed markets. If they stagnate or destabilize, investors are likely to flee. Investors who are willing and able to endure such evolution and risk may be able to stake their claim in tomorrow’s frontiers.

Mike DuCharme – Head of Foreign Exchange, Business Growth and Development – Russell Implementation Services