Emerging and frontier Markets refer to that are not yet fully developed but exhibit some level of market activity, openness, and stability. These Markets present investors with opportunities for higher returns, diversification, and exposure to novel growth prospects. However, they also come with increased risks, volatility, and uncertainty, including challenges like political instability, regulatory barriers, and limited transparency. This section will examine the advantages and disadvantages of investing in emerging and frontier Markets, focusing on aspects such as risk, return, diversification, and valuation.
Some of the benefits and drawbacks of investing in emerging and frontier Markets are:
1. Risk
Investing in emerging and frontier Markets entails higher risk compared to developed Markets due to their increased vulnerability to economic, political, and social shocks, such as currency crises, civil unrest, corruption, and governance issues. These factors can impact asset performance and liquidity, as well as the safety and security of investors. For instance, Turkey’s currency crisis in 2018 led to a sharp depreciation of the lira, significantly diminishing the value of its stocks and bonds.
Conversely, investing in emerging and frontier Markets can enhance portfolio diversification by exposing investors to diverse sources of growth and innovation. These Markets often exhibit lower correlation with developed Markets, meaning they may not move in tandem with global market trends. For example, despite the COVID-19 pandemic’s global impact, China managed to achieve positive economic growth in 2020, which positively affected its equity and debt Markets.
2. Return
Investing in emerging and frontier Markets can potentially yield higher returns compared to developed Markets, due to their higher growth potential, lower valuations, and greater scope for improvement. These Markets often benefit from factors such as favorable demographics, increasing incomes, urbanization, infrastructure development, and technological adoption, which can drive economic expansion and enhance the profitability and competitiveness of companies. Additionally, these Markets may offer attractive valuations, as they are frequently undervalued or overlooked by investors, creating opportunities for bargain hunting and value investing. For example, in 2019, Vietnam emerged as one of the world’s top-performing stock Markets, delivering a 17.7% return, driven by its robust economic growth, trade surplus, and foreign direct investment.
However, investing in emerging and frontier Markets also carries risks that can lead to lower or negative returns. These Markets are more volatile and unpredictable, subject to various external and internal shocks. They may encounter challenges such as rising inflation, interest rates, debt levels, and trade tensions, which can hinder economic growth and diminish investor confidence. For instance, in 2020, Argentina defaulted on its sovereign debt for the ninth time, resulting in a severe sell-off of its bonds and stocks.
3. Diversification
Investing in emerging and frontier Markets can enhance portfolio diversification by providing exposure to different regions, sectors, and themes that are underrepresented in developed Markets. These Markets may offer access to unique opportunities such as frontier technologies, renewable energy, e-commerce, and consumer discretionary sectors, which can potentially yield higher returns with lower competition. Additionally, their distinct economic cycles and drivers can reduce a portfolio’s dependence on developed Markets, thus mitigating sensitivity to their performance and events. For instance, in 2021, Nigeria became the first African nation to issue a green bond, raising $41 million to support renewable energy projects and appealing to investors focused on environmental, social, and governance (ESG) criteria.
However, investing in emerging and frontier Markets can also constrain diversification by increasing exposure to similar or correlated risks prevalent in these regions. Common vulnerabilities such as currency fluctuations, commodity dependence, capital outflows, and geopolitical tensions can amplify portfolio losses and volatility. For example, the oil price collapse in 2014 led to recessions and currency crises in several emerging and frontier Markets, including Russia, Brazil, and Nigeria, adversely affecting the returns and stability of their assets.
4. Valuation
Investing in emerging and frontier Markets can offer superior value compared to developed Markets due to their lower valuations and higher earnings relative to their assets, growth potential, and profitability. These Markets often exhibit lower price-to-earnings (P/E), price-to-book (P/B), and price-to-sales (P/S) ratios, suggesting they are more affordable and potentially more attractive investments than their developed counterparts. Additionally, emerging and frontier Markets may demonstrate higher earnings growth, dividend yields, and return on equity (ROE), indicating greater profitability and rewards. For instance, as of February 2021, the MSCI Emerging Markets Index had a P/E ratio of 18.4, a P/B ratio of 2.1, a P/S ratio of 1.6, earnings growth of 23.9%, a dividend yield of 1.8%, and an ROE of 11.5%. In comparison, the MSCI World Index had a P/E ratio of 24.6, a P/B ratio of 2.9, a P/S ratio of 2.5, earnings growth of 18.2%, a dividend yield of 1.6%, and an ROE of 10.4%.
However, investing in these Markets can also present inferior value compared to developed Markets due to higher risks and uncertainties. Emerging and frontier Markets typically exhibit greater volatility, beta, and maximum drawdowns, indicating higher instability and potential for losses. These Markets may also face challenges such as lower quality, liquidity, and transparency, making them more difficult and costly to access and analyze. For example, as of February 2021, the MSCI Frontier Markets Index had a volatility of 16.9%, a beta of 0.8, and a maximum drawdown of 54.7%, whereas the MSCI World Index had a volatility of 14.5%, a beta of 1.0, and a maximum drawdown of 50.8%.
