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As we go about making asset allocation decisions in our investment portfolio, we are sure to focus on the usual suspects like Australian shares, international stocks, bonds, and even emerging markets. However, we often overlook opportunities in economies in frontier markets. These markets can offer benefits lacking from the rest of your portfolio, if selected carefully.

So how do you define frontier markets?

Broadly speaking, countries, such as Bangladesh, Bulgaria, Kenya, Nigeria, Sri Lanka or Vietnam, fall into this category since they have capital markets less developed than emerging ones.

These countries make up just a small percentage of the global economy - 4% - and 1% of the global market cap. Companies in frontier markets tend to be smaller, and their stocks illiquid, relative to their emerging market counterparts. Most of these countries lack wealth. However, many of them are transforming rapidly. This can deliver you growth in the backdrop of a global slowdown. Imagine investing in China in the late ‘70s or early ‘80s. Investors needed nerves of steel to participate in the young economy at the time. However, reforms led to more open markets, facilitating trade and commerce. Now China is the world’s manufacturing hub.

Today’s frontier markets are tomorrow’s emerging gems. Obviously, not all frontier markets will become flourishing economies, though. Some will lose their way. That’s why you must research the growth story, track relevant drivers, and discover the companies that will benefit as progress takes hold. But before you leap, know these five truths of frontier markets that can’t be ignored.

Diversifying Benefits

Popular perception of frontier markets is that they are highly volatile. While that’s true, they can actually reduce the volatility in your own portfolio by virtue of diversification. That’s because frontier countries aren’t as correlated with developed and developing market movements. For example, for the 5-year period ending June 2014, FTSE Frontier Index had a correlation of 0.51 with the FTSE All Cap Emerging Index and 0.58 with the FTSE All Cap Developed Index. The Emerging and Developed indexes, on the other hand, moved closely together, with a 0.88 correlation. This can protect gains in your portfolio when developed & developing markets struggle.

Tracking Friendly Reforms

Most of the frontier economies you would invest in are experiencing huge growth, albeit from a low starting point. An enticing frontier economy has some typical tailwinds in its favour – a young and growing population, improving educational system, growing labour force and urbanization. Implementing business and market friendly reforms, such as simplified tax policies, investments in infrastructure or the cutting of red tape can go a long way to promote continued growth and employment. Look for countries that are moving up the value chain by diversifying from agriculture to manufacturing. With rising wages in China, countries like Vietnam and Bangladesh have stepped in to offer cheaper manufacturing options. Continuing positive reforms will key these countries’ ongoing momentum. Watch how the countries track with future or proposed reforms. It’ll give you insight into how serious the governments are to promote the growth story.

Finding The Right Management

One of the key challenges of getting exposure to structural growth in a frontier market economy is the lack of options on its trading exchange. Many of the exchanges are in their infancy and do not have many companies listed. Not only that, but there’s often little corporate governance. Many companies will not even host a conference call after reporting quarterly earnings! Consequently, very few brokerages have direct access to these exchanges making it difficult for retail investors. To add to that, some of the most mature businesses in such countries tend to stay private, in order to maintain control and avoid public scrutiny. Therefore, seek companies that have a management group with a history of putting the company ahead of short-term personal gains.

Avoiding Geo-Political Conflicts

Geo-political risks often impact performance. Years of reforms and developments could get unwound in a short period of time. Corrupt elections, military coups, civil war or militant insurgencies – the list goes on – cripples investor confidence, leading to widespread selloffs. Sometimes it could take businesses in these regions years to recover. Nigeria, for example, has one of the largest African economies, yet it faces frequent challenges to its stability due to terrorism. Make sure to stay well versed in the region and re-assess your investment portfolio if unrest begins to bubble.

Divesting Difficulties

Last, but certainly not the least, is the liquidity risk that comes with frontier equities. Companies tend to be small with low trading volumes. Some stocks might not even produce a trade on any given day. It can be difficult to exit big positions in such markets, so factor that in to your investment decisions as well. We live in an environment of global slowdown, where both earnings growth and yield are scarce. While frontier markets may not cure all ills, it can certainly provide diversification benefits and access to overlooked growth options. Like any investment, make sure to do your research and remain selective about the economies and stocks you buy. Then, when you see an opportunity, jump onto the wave of a frontier growth story. You’ll enjoy the adventure.

Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.

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