Equity markets in the traditional emerging regions of Brazil, Russia, India and China are no longer considered as risky as they were 20, or even 10 years ago, meaning investors should be looking to younger frontier markets as candidates to fill the gap.
Money markets in frontier nations are becoming more sophisticated, corporate governance is improving and the majority of these countries are much more politically stable than they have been before.
"There are certainly some signs that Asia in particular is starting to mature and move away from the emerging markets," said Adrian Lowcock, senior investment adviser at Bestinvest. "Bits of south-east Asia are now considered developed. South Korea, for instance, is an Emerging Market in the MSCI index but not FTSE. Singapore, Hong Kong and Australia are all developed markets whilst Malaysia and Thailand are still emerging."
"Frontier markets are sub-emerging and the interest in this area is due to China’s expansion and investment into regions that can support its growth to a developed market. They are highly illiquid and highly risky but the long-term story is still quite strong."
Hargreaves Lansdown’s Rob Morgan says that part of the excitement about investing in the world’s youngest markets is that they can stagnate for years and then explode seemingly overnight.
"Frontier markets are reliant on different catalysts to the rest of the market but things can move very quickly," he said. "Nations are skipping whole stages of development because the progress of handheld communication devices means that businesses are not reliant on getting a phone line in or a computer network set up. China is also investing aggressively in Africa to get access to the region’s wealth of natural resources."
Another argument for investing in frontier markets is that traditional emerging regions are becoming coupled to equity markets in the West. The recent soft-closure of Aberdeen Emerging Markets and a number of First State Emerging Markets funds has also narrowed the options in the sector.
In terms of correlation, data from FE Analytics shows that over the last three years the MSCI Emerging Markets index has had an r-squared ratio of 0.69 per cent in relation to the FTSE All World Developed index, while the MSCI Frontier Markets index has a ratio of just 0.21 per cent.
The MSCI Frontier Markets index has also been substantially less volatile over that period.
While there are a number of focused frontier market funds such as Templeton Frontier Markets, managed by Dr Mark Mobius and Fidelity Emerging Europe Middle East & Africa, Morgan says that investors would expose themselves to less risk through a more broad-based fund such as JM Finn Global Opportunities.
Our data shows the fund has returned 73.36 per cent over the last three years, compared with 44.53 per cent from the average fund in the global sector.
Performance of fund vs sector over 3-yrs
Source: FE Analytics
The fund is headed up by FE Alpha Manager Anthony Eaton, who also runs the more concentrated JM Finn Africa portfolio.
Morgan commented: "JM Finn Global Opportunities plugs into demographic trends all over the world and with 7.6 per cent in the Middle East and Africa, Eaton is looking to make quite a big play in frontier markets."
Lowcock warns that frontier markets should only be used as a satellite play as part of a diversified portfolio and only for investors with a lengthy horizon.
"When investors become risk-averse they sell from these sorts of areas first and that is the hill they have to climb," he said. "Whilst volatility remains high in equity markets all over the world it is difficult to recommend that investors significantly increase their exposure."
"However, change is coming. Asian income is a strongly developing theme and dividend policies are a sign of good corporate governance and more stable economies. Politically, governments are much more stable and financially robust than the West. For investors with 10 or 20 years left before they need the money, then the argument is quite strong, but do so when markets weaken."