Frontier Markets: Understanding the Risks

Abstract

In the search for performance and diversification, an increasing number of investors are spicing up their portfolios with frontier market exchange-traded funds. Many factors have led them to gradually consider strategic allocations to these areas, not the least of which is the fact that emerging economies have become more correlated with developed economies. This study examines whether these small economies are suitable to the average investor in regard to the size of their markets, liquidity, and risk-adjusted performance. It is concluded that, for now, only their undeniable diversification benefits—an outcome that modern portfolio theory has taught us to highly value—tilt the odds in their favor.

TOPICS: Exchange-traded funds and applications, frontier markets, risk management

Key Findings

• • Frontier market exchange-traded funds (ETFs) are clearly distinct from their more-developed counterparts, unlike emerging markets, which have become increasingly coupled with developed countries over time. Frontier markets can add meaningful diversification to a portfolio.

• • The risk-adjusted performance of frontier market ETFs, however, significantly lags that of the SPDR S&P 500 ETF Trust (SPY), a fund used to assess the opportunity cost to invest in these countries in lieu of the United States.

• • Frontier market ETFs also exhibit high concentration ratios, which could subject them to significant cash outflows from redemptions by a small number of investors.