Frontier Markets Beckon Investors

The most adventurous investors now have somewhere new to explore: frontier markets. Think of them as pre-emerging -- the kind of markets that make China and India stocks look cosmopolitan. Everyone has a different interpretation of what fits the definition of frontier, but we mean the likes of Kazakhstan, Kenya, Kuwait, Qatar and Vietnam. Africa -- both north and sub-Saharan -- and the Middle East are particularly hot frontiers now.

The allure rests in the higher growth rates of these nascent economies, many expanding at annual rates of 6% to 10%, compared with anemic rates of 2% or less in many developed countries. Africa is riding the commodities wave, exporting oil, metals and agricultural products to resource-hungry trading partners, including China. Meanwhile, once-crushing debt obligations have been paid back or forgiven, helping to stabilize currencies and setting the stage for fiscal reforms.

In the Middle East, it's all about petrodollars. Huge budget surpluses from the rise in oil prices and a push to diversify local economies are leading to massive building projects. Qatar and Dubai are becoming financial hubs and tourist destinations. In such fledgling economies, beneficiaries include banks as well as construction, real estate, retail and wireless-telecommunication firms.

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The other attraction of frontier markets is that they share little correlation with other global holdings -- or even with one another. Whereas developed international markets track 85% of the movement of Standard & Poor's 500-stock index and emerging markets overall track 75%, frontier markets are in sync just 55% to 60% of the time.

Wall Street's marketing machine is latching on in a big way. Since June, at least five exchange-traded funds have rolled out. Among actively managed funds, T. Rowe Price Africa & Middle East (symbol TRAMX) has grown to $814 million in assets since its debut in September 2007. Fidelity introduced Emerging Europe, Middle East, Africa (FEMEX) in May (although the bulk of assets are in the region's more developed countries).

Is this more than a passing fad? Fans say frontier markets, which account for just 1% of stock-market assets, are where emerging markets overall stood in 1987. But there's no guarantee that gains of the same order of magnitude will be repeated. And the risks are truly hairy -- political unrest and instability, armed conflict, a scarcity of research and weak accounting rules, all of which foster volatility. Some stock markets are open only an hour or two a day.

Frontier markets are best for investors with not just years but decades to spare, and should account for only a portion of assets earmarked for emerging markets. Make sure you're not doubling up with overlapping investments that involve other international or emerging-markets plays, and especially commodities.

Until some track records emerge, we'd choose an actively managed fund over the passive approach of an ETF. T. Rowe's team is led by Christopher Alderson, who also manages the firm's excellent Emerging Markets fund. Up 22% in the fourth quarter of '07, the fund is down 5% so far this year, falling in sympathy when oil prices deflated a bit. But so it goes on the frontier.