The most exotic place most Canadians will invest is the New York Stock Exchange, so the idea of buying stocks in a tiny country on the other side of the planet may feel risky. And it is, especially considering the S&P 500 index has more than doubled from its low during the financial crisis in March, 2009. With returns like that, why look anywhere else?
But there is a gap between the perception and reality of frontier markets, according to money managers, who rely on country visits to understand and manage risks from the likes of government, regulators, brokers and managers. Investors also need to remember that the S&P 500 plunged by more than half in the 17 months before its 2009 low.
"The most misunderstood point is that frontier markets are low risk," said Larry Speidell, chief investment officer at California-based Frontier Market Asset Management LLC. "We had an effective global financial collapse, which has made S&P 500 companies seem like the safest on earth. I think it's time to think outside the box."
Although stocks and currencies in individual frontier markets may swing up and down more than in emerging countries, – or stop trading for months, as during the 2011 revolution in Egypt – as a group, they are less volatile, as measured by their five-year annualized standard deviation. As of Dec. 31, volatility stood at 18.5 per cent for the MSCI Frontier Markets Index, compared with 22.6 per cent for the MSCI Emerging Markets Index and 15.3 per cent for the S&P 500.
Frontier markets are, by definition, smaller than emerging and developed markets, with less information, lower liquidity and higher transaction costs. It's important to spend time on the ground, and find brokerages that execute trades reliably and properly, Mr. Speidell says.
Exploiting inefficiencies in pricing and liquidity is part of the strategy used by Thomas Vester, who manages $800-million in frontier stocks for Bank of Montreal's Lloyd George Management in London.
He acknowledges that scandals and fraud are possible, just as in developed markets, he said, citing the cases of Bernard Madoff, Enron Corp. and WorldCom Inc.
"You need to be diversified so you can live with abnormal events in your markets," Mr. Vester said.
For all their perceived risk, returns this year to Feb. 4 show frontier markets can add value to a portfolio. They gained 0.9 per cent, while emerging markets dropped 2.3 per cent and the S&P 500 plunged 5 per cent.