Financial advisers are eyeing the next investment frontier

As emerging markets increasingly move in lock step with developed markets, some financial advisers are considering putting their clients' assets into frontier markets — in less developed and inherently more risky countries — in hopes of generating higher returns.

Frontier markets, marked by low market capitalization and liquidity, include countries across Africa, such as Ethiopia and Ghana, as well as Eastern Europe, the Middle East and South America.

Even though these countries come with considerable risks, such as political upheaval and a low standard of living, some advisers see similarities between frontier markets today and such emerging markets as Brazil or China 10 or 15 years ago.

“We're seeing a lot of the same stories in frontier markets as we did in emerging markets,” said Chad Carlson, wealth manager at Balasa Dinverno Foltz LLC. “There's a lot of economic im-provement that could happen.”

That said, as a group, frontier markets haven't done nearly as well as larger developing markets.

The MSCI Frontier Markets Index was up just 0.99% year-to-date through May 9, compared with the MSCI Emerging Markets Index's 6.71% rise. For the one- and three-year periods, the MSCI Frontier Markets Index was down 16.3% and up 1.80%, respectively — compared with the MSCI Emerging Market Index's decline of 15.84% and gain of 10.48%, respectively.

Mutual funds that invest in frontier markets also tend to cost more than their less aggressive brethren.

The $357 million Templeton Frontier Markets Fund (TFMAX), for example, comes with an expense ratio of 2.5%. That is significantly higher than the 1.47% expense ratio for the Templeton Developing Markets Fund (TDADX), which invests in emerging markets.

“They're just too expensive, for the most part,” Mr. Carlson said.

Although some fund companies offer limited exposure to frontier markets through their emerging-markets funds, a handful offer funds focused exclusively on frontier markets, including Franklin Templeton Investments and Wasatch Funds. Guggenheim Investments offers an exchange-traded fund focused on frontier markets, the Guggenheim Frontier Markets ETF (FRN).

And MSCI recently launched what it calls “a more liquid” frontier-markets index that BlackRock's iShares business has licensed for a future ETF.

Interest in frontier markets is no doubt being fueled by the outperformance of emerging markets over much of the past decade.

The average emerging-markets-stock fund has a 10-year annualized return of 12%, compared with just 4.4% for the S&P 500. As a result, assets in such funds stand at $250 billion, up from just $14 billion 10 years ago, according to Morningstar Inc.

NET INFLOWS

Over the one-year period ended March 31, emerging-markets-stock funds experienced $21 billion in net inflows, more than any other fund category, according to Morningstar. Funds of large-cap U.S. stocks, meanwhile, experienced net outflows of $76 billion, Morningstar said.

As money has gushed into emerging markets, those markets have become more correlated with developed markets — thereby diluting one of the main benefits of investing in them in the first place.

Correlations between developed and emerging markets stand at about 0.9, according to Thomas Coleman, head of emerging-markets-equity strategies for North America at State Street Global Advisors.

By comparison, correlations between developed markets and frontier markets stand at 0.6, he said.

A correlation of 1 means the two categories are moving in perfect unison.

Consequently, many institutional investors — and now some financial advisers — are adding frontier markets to their portfolios.

“Frontier markets are still fairly localized and not affected as much by global swings,” he said. “With the correlation to global markets still relatively low, they can lower the overall risk of the portfolio,” Mr. Coleman said.

Brian Kazanchy, chairman of the investment committee at RegentAtlantic Capital LLC, added frontier markets as a small piece of clients' international buckets for that reason.

“We've taken the plunge,” he said. “It's small right now, but it's something we could potentially grow over time.”

A “plunge” might be an apt description for investing in the frontier markets today. Although they may offer diversification and the potential for long-term outperformance, there is no doubt in anyone's mind that there are going to be a lot of bumps along the way.

“Be prepared to stomach the volatility,” said Todd Henry, a portfolio specialist at T. Rowe Price Investment Services Inc.

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