Do you want to diversify your portfolio? Explore new territories for long-term growth

Global stock markets are performing strongly, seemingly able to overcome all obstacles. Investors in the UK market reacted with composure to the political volatility of the past week or so, with the FTSE 100 barely moving after the unexpected election risk.

So where, then, do you invest if you want to diversify your portfolio in these ostensibly stable markets and secure long-term growth potential?

A number of experts believe now is the time to look beyond the big industrial nations and emerging economies to invest in frontier markets. These are in countries that account for 12 per cent of the world’s population and generate 4 per cent of global economic output, yet they are generally ignored.

Fund managers see an increasing opportunity here. Last month Jupiter Asset Management raised almost £90 million from investors for a new fund that will invest a substantial chunk of its assets in frontier markets. Franklin Templeton has announced plans to reopen its $800 million (£683 million) Frontier Markets fund to new investments after closing it in 2013.

John Scott, who will run the Jupiter Emerging & Frontier Income Trust, describes the fund as “an exciting opportunity for investors to access some of the world’s fastest-growing investment markets”, which is the allure of these economies.

Frontier markets have not yet been through the transformation of emerging markets. In many cases trends such as urbanisation, population growth and globalisation are only just beginning to have an impact, which provides opportunity for investors.

Frontier market economies are at an earlier stage of the development cycle — where emerging markets were, say, 20 years ago. They include Asian nations such as Bangladesh, Pakistan, Sri Lanka and Vietnam, but also African countries such as Botswana, Ghana, Kenya and Morocco, states in the Middle East such as Bahrain, Jordan, Kuwait and Qatar, and Argentina in Latin America.

Europe also has a host of frontier markets such as Bulgaria, Romania, Cyprus and Malta. Further afield is Kazakhstan. “New opportunities are emerging all the time,” says Juliet Schooling Latter, a research director at the financial adviser Chelsea Financial Services. She says a “small allocation” to frontier markets makes sense for investors with a large portfolio of international funds.

“These markets are under-researched and some trends are going in their favour,” she says.

“For example, a significant amount of manufacturing is being moved to Vietnam, rather than China, because wages are lower there. Many managers are also positive about Pakistan, and Iran has just opened its already quite established stock market.”

There are risks: Ukraine’s stocks fell 38 per cent in 2015

Still, frontier markets vary greatly. Many are dependent on the fortunes of the commodity markets — oil in the case of Nigeria and the Middle Eastern states, and cotton in Pakistan. Others are a play on the power of the consumer, such as a growing consumption of meat and fish, say, or increasing demand for household items.

Yet development is not a one-way street. Some countries move from frontier status to emerging markets and keep developing; others go backwards. Argentina, for example, was considered an emerging market five years ago, but political uncertainty and restricted access to its stock market have led it to be downgraded by investors.

“You certainly have to be realistic about the risks, but frontier markets can provide an edge in a portfolio dominated by mainstream stock market funds,” says Sam Lees of Fund Expert, the research service. “While these markets are an eclectic bunch, the size of the economy or income per head is not a big issue — more important is political stability, a sound legal and regulatory system, and financial markets that are sufficiently developed for investors to get in and out.”

With many frontier markets making progress on these criteria, aggregate performance has been strong. Converting returns back into pounds for UK investors, the MSCI Frontier Markets Index rose by 70.4 per cent over the five years to the end of April. In contrast, the MSCI Emerging Markets Index was up by 32.8 per cent.

Clearly there are risks, with the headline figures masking some big variations. Sometimes losses can be disastrous. For example, Ukraine’s stock market fell 38 per cent in 2015 after the country’s civil war escalated, while Cyprus, hit by the financial crisis in 2014, lost 20 per cent.

“Frontier markets offer big potential growth, but also risk and volatility, says Adrian Lowcock, the investment director at the investment platform Architas. “This is an investment where you must be willing to tolerate significant falls — during the financial crisis the MSCI Frontiers Index fell by 61 per cent.” However, while it is wise to be wary of the dangers of investing individually in these markets, frontier markets as an asset class may be less risky than investors imagine.

One advantage is that they are less connected through globalisation, so individual markets trade independently of one another. The availability of bank finance to small businesses in Bulgaria, say, has no effect on demand for a Botswanan retailer’s products.

For this reason funds that are diversified across a number of frontier markets are often less volatile than supposedly safer funds, which invest across markets that move in unison.

Equally, frontier markets offer fund managers greater opportunities to spot ideas, trends and successful businesses that other investors have missed. Many emerging markets are so well-known by a global investment audience that fund managers find it almost impossible to beat the average.

Tony Lawrence, an investment manager at Seven Investment Management, says these benefits aren’t expensive to secure. “In a world still largely devoid of meaningful opportunities, you can buy [frontier markets] at a discount to developed and emerging counterparts,” he says. “You will also receive a far higher dividend yield to help mitigate any lingering concerns.”

Add the potential for portfolio diversification and the macro-economic backdrop, and the arguments for investors able to take a long-term view are even more compelling.