Is the frontier market still too wild and risky?

It's tempting to seek large returns in volatile sectors – but be careful, warns Emma Dunkley

Development drag: The potential growth in South East Asia is one area targeted by frontier funds (OANG DINH NAM / AFP )

As Europe sits on the cusp of recession and the UK faces years of low growth, the prospect of investing in a Western economy for stellar returns seems fanciful at best.

As sentiment on the region plunges, more people are turning to the likes of China and those countries dubbed as emerging markets to buy shares, according to a survey by Baring Asset Management.

But emerging markets have come a long way in the past 10 years and are spearheading the global economy to the point where they are no longer fledgling markets facing a teenage growth spurt.

If you are kicking yourself for not investing in the budding emerging markets a couple of decades ago, "frontier" markets such as Kuwait or Kenya are now being touted as the next generation. Between 1992 and 2007, these markets actually had higher rates of growth than the broader emerging markets, at around 12 per cent a year compared with 9 per cent.

"These economies are in the early stages of development, where capital markets have been opening up and there is strong growth potential," says Meera Patel, senior investment analyst at Hargreaves Lansdown. "Frontier markets are at a stage where many of today's popular emerging markets were 10 to 15 years ago."

Although frontier markets have soared over the past two decades, many people are wary of these new kids on the block. They tend to behave differently from developed markets, which can be considered an attractive quality, given the weak outlook in the West at the moment. Ben Seager-Scott, a senior analyst at Bestinvest, says: "Of course, investors need to be aware that these are risky investments and political risk remains high, brought into sharp focus by the various uprisings we saw in this region earlier in the year."

With many of the frontier markets based in the Middle East and Africa, such risks as the Arab Spring remain evident, although there are others lurking beneath the surface. In 2009, fund manager New Star wound up its Heart of Africa trust, and investors lost a sizeable chunk of their money.

Part of the problem leading to the fund's demise is the less mature nature of these markets, and the difficulty this causes when trying to buy or sell certain shares in the region. Patrick Connolly of AWD Chase de Vere says: "The increased volatility and greater risks of investing in frontier markets over recognised emerging markets, with poorer infrastructure and corporate governance, illiquidity and increased political risks, makes them unsuitable for the overwhelming majority of investors."

The thought of buying into frontier markets to make a quick buck would certainly be erroneous. Ms Patel says: "Investors need to remember that these are less developed markets and growth may be achieved over time, but with potential bottlenecks along the way." Among the possible stumbling blocks include a lack of adequate regulations in the country, and fluctuating exchange rates.

But for those who are insistent on seeking potential growth over the long-term via frontier markets, collective schemes are one of the best routes. Investment trusts are one of the most popular products in this space, as they have the scope to invest in smaller and harder-to-trade stocks.

However, rather than buying a fund that invests solely in these countries, there are funds which also have exposure to the broader emerging markets, which can help to dilute exposure to any potentially risky area. Ms Patel says: "I would suggest investors gain exposure to the higher risk markets via an emerging market fund. If risk appetites allow, then a very small exposure to a dedicated frontier markets fund could be an option."

You don't even have to buy into these markets directly to gain access. Ben Willis, head of research at Whitechurch Securities, says a lot of frontier markets are rich in natural resources, so investors buying a commodities fund, say, could gain exposure to these countries via this route. "In addition," he says, "many of these global resource funds invest in developed-market companies whose operations are based in frontier markets."

Despite a shift in sentiment towards the emerging markets, people are not necessarily allocating a greater proportion of their assets in favour of these frontier countries. A lot of people are shying away from equities, as witnessed by the extreme swings in stock markets this year. "Many investors are being forced into equities for yield and growth reasons and are begrudgingly accepting the risk that this entails," says Mr Willis. "However, most are still uncomfortable with taking on excessive risk, and the wide perception remains that investing in frontier markets equates to very high risk."

In a climate where the sovereign debt crisis still rages on in Europe, many people are becoming even more risk-averse, erring on the side of caution. And even though the broader emerging markets have been on the radar for the past couple of decades, it is only recently that people have become more comfortable with investing their money in them.

Ms Patel says: "It will take some years before investors are confident enough to increase their allocation to these specialist funds."

Many advisers think that investors should have less money than in the past in the UK, Europe and the US, with a greater proportion invested in emerging and frontier markets. But investors who may need their money at relatively short notice – if, for example, they are close to retirement – are still recommended to go into less volatile investments such as UK equities, bonds, or even cash savings accounts.

Emma Dunkley is a reporter at Citywire.co.uk

Expert View

Meera Patel, Hargreaves Lansdown

"Investors should be aware of the risks [of frontier markets], such as lower levels of liquidity, political and economic instability and lack of adequate regulations. If in doubt, I believe investors may wish to consider a broader emerging markets fund which could offer some exposure to the smaller frontier markets."

Maximum Exposure

In the vanguard: the frontier funds

HSBC's research forecasts that by 2050, the size of emerging market economies will increase fivefold and will be larger than the developed world. The main funds operating in these areas include:

Investec's Africa & Middle East fund

Return: Around 18 per cent in the past three years. Manager Roelof Horne. Aims long-term returns via equities of firms based in Africa or Middle East, or which derive a significant revenue from the region. Exposure Nigeria, Egypt, UAE.

Templeton Frontier Markets fund

Return: 35 per cent over three years. Manager Mark Mobius, above. Aims to deliver long-term returns by investing mainly in equities of firms in the region, or that have principal activities there. Main exposure Nigeria, Vietnam, Kazakhstan, Qatar.

BlackRock Frontiers Investment Trust

Formed a year ago. Manager: Sam Vecht.

Schroders Frontier Markets Equity fund

Launched 2011. Managers: Allan Conway and Rami Sidani.

HSBC Global Asset Management's GIF Frontier Markets fund

Manager: Andrea Nannini.