What Is Frontier Markets?
Frontier markets are a classification of developing economies that are considered to be in an earlier stage of capital market development than "emerging markets." These markets typically exhibit smaller market capitalization, lower liquidity, and higher levels of risk and volatility compared to more established markets71, 72, 73, 74. They fall under the broader financial category of global equity markets and are often characterized by nascent financial systems, less developed infrastructure, and lower levels of industrialization70.
Investing in frontier markets can offer potential for high economic growth and attractive returns due to their early stage of development and the possibility of "catch-up growth"69. However, these opportunities come with increased challenges, including political instability, regulatory complexities, and limited access to capital66, 67, 68. Despite these factors, frontier markets are increasingly considered by investors seeking to enhance diversification within their portfolios65.
History and Origin
The concept of "frontier markets" was introduced by the International Finance Corporation (IFC) in the early 1990s64. This classification emerged as a way to distinguish a subset of developing economies that were opening to foreign investment but were still less developed than what were then becoming recognized as "emerging markets"62, 63. The term provided a more nuanced view of the global investment landscape, acknowledging a spectrum of development stages beyond simply "developed" and "emerging." The MSCI Frontier Markets Index, a widely referenced benchmark for this asset class, was launched on May 31, 200261.
Key Takeaways
- Frontier markets are developing economies with smaller, less liquid, and less accessible capital markets than emerging markets.59, 60
- They are characterized by high potential for economic growth and offer significant diversification benefits for investor portfolios.57, 58
- Investing in frontier markets involves heightened risks, including political instability, regulatory shortcomings, and limited market liquidity.54, 55, 56
- Major index providers like MSCI classify countries as frontier markets based on various criteria, which can include market capitalization, liquidity, and investment restrictions.52, 53
Formula and Calculation
There is no specific formula for "frontier markets" themselves, as it is a classification of countries rather than a quantifiable metric like a financial ratio. However, financial indexes that track frontier markets, such as the MSCI Frontier Markets Index, are calculated based on the market capitalization of eligible companies within those countries.
The general formula for calculating market capitalization is:
For an index, the weights of individual securities are often determined by their free-float market capitalization, which considers only shares readily available for trading in the public market50, 51. These calculations contribute to the overall index value, which reflects the performance of the frontier market segment it represents.
Interpreting Frontier Markets
Interpreting frontier markets involves understanding their unique characteristics and the potential implications for investors. These markets are typically in the early stages of economic development and often possess significant untapped growth potential driven by factors such as young and growing populations, urbanization, and increasing consumer spending48, 49. However, this potential is balanced by inherent risks.
Analysts and investors evaluating frontier markets consider factors like political stability, regulatory frameworks, currency volatility, and the overall macroeconomic environment45, 46, 47. While they may offer higher potential returns, the increased risk-adjusted returns often come with greater exchange rate fluctuations and lower market transparency42, 43, 44. A thorough understanding of these dynamics is crucial for making informed investment decisions.
Hypothetical Example
Consider an investor, Sarah, who has a well-diversified portfolio primarily focused on developed and emerging markets. Seeking to further enhance her portfolio's diversification and potentially capture higher growth, she decides to allocate a small portion to frontier markets.
Sarah researches several frontier market exchange-traded funds (ETFs) and decides on one that invests in a basket of companies across various frontier countries in Southeast Asia and Africa. She allocates 2% of her total portfolio to this ETF.
Over the next five years, while her developed market investments experience moderate growth and her emerging market holdings see some volatility, the frontier market ETF performs exceptionally well due to robust economic growth in some of the underlying countries and increasing foreign direct investment. Although individual companies within the frontier market ETF might experience significant price swings, the overall portfolio benefits from the lower correlation of frontier markets with her existing holdings. This hypothetical example illustrates how a strategic, albeit small, allocation to frontier markets can potentially contribute to overall portfolio performance and diversification.
Practical Applications
Frontier markets serve as a frontier for investors seeking new sources of growth and diversification in their portfolios. One practical application is for institutional investors and fund managers looking to achieve a broader global asset allocation. By including frontier markets, they can potentially reduce overall portfolio volatility by investing in markets that may not move in lockstep with developed markets or even some emerging markets40, 41.
These markets also present opportunities for investors interested in sectors that are in the early stages of development, such as consumer staples, telecommunications, and financials, driven by rising populations and nascent middle classes38, 39. Furthermore, private sector solutions and foreign direct investment in frontier economies can address critical development issues like poverty and limited infrastructure, creating unique investment opportunities with potential for social impact37. For example, a Reuters article from January 2025 noted that some investors are increasingly looking to frontier markets, particularly in Africa, as a potential hedge against global geopolitical and macroeconomic factors, seeking shelter from the impact of trade policy shifts36.
Limitations and Criticisms
Despite their potential, frontier markets come with significant limitations and criticisms. A primary concern is their relatively high political risk and instability, which can lead to unpredictable policy changes, expropriation of assets, or social unrest34, 35. Governance issues, including corruption and lack of transparency, also pose substantial challenges for investors32, 33.
Furthermore, these markets often suffer from low liquidity in their financial markets, making it difficult to enter or exit positions without significantly impacting prices28, 29, 30, 31. This illiquidity can be particularly problematic during periods of market stress, as observed during the COVID-19 pandemic when some local-currency bonds paradoxically became more liquid than hard-currency bonds due to concentrated mutual fund exposure27. Critics also point to the underdeveloped regulatory frameworks and weaker investor protections in frontier markets compared to more mature economies26. An academic study highlights that while frontier markets offer undeniable diversification benefits, these are often balanced by the smaller market sizes, lower liquidity, and overall higher risk levels, making them less suitable for the average investor25.
Frontier Markets vs. Emerging Markets
Frontier markets and emerging markets are both classifications for economies undergoing development, but they represent different stages of growth and market maturity.
| Feature | Frontier Markets | Emerging Markets |
|---|---|---|
| Development Stage | Earlier stage of economic and capital market development. | More advanced, transitioning from low-income to higher-income economies. |
| Market Size | Smaller market capitalization. | Larger market capitalization and more developed financial systems.24 |
| Liquidity | Lower liquidity, can be challenging to trade securities. | Generally more liquid than frontier markets.22, 23 |
| Accessibility | Less accessible to foreign investors due to restrictions. | More open and integrated into the global economy. |
| Risk & Volatility | Higher inherent risks (political, regulatory, currency). | Still higher risks than developed markets, but generally less volatile than frontier markets.19, 20, 21 |
| Index Inclusion | Form a distinct category within global investment indexes (e.g., MSCI Frontier Markets Index). | Included in major indexes like the MSCI Emerging Markets Index.16, 17, 18 |
While emerging markets have become a mainstream term in the investment community, frontier markets are still largely confined to a more specialized group of international investors15. Investing in both can offer different levels of risk and reward within a diversified portfolio, with frontier markets often considered a "pre-emerging market" class13, 14.
FAQs
What defines a country as a frontier market?
A country is typically defined as a frontier market based on its stage of economic and capital market development. Key characteristics include smaller market capitalization, lower liquidity, less developed financial systems, and a higher degree of investment restrictions compared to emerging markets11, 12. Index providers like MSCI use specific criteria related to market size, liquidity, and accessibility to classify countries9, 10.
Why do investors consider investing in frontier markets?
Investors consider frontier markets for their potential for high economic growth and the significant diversification benefits they can offer. Due to their low correlation with developed and even emerging markets, including frontier markets in a portfolio can help reduce overall volatility and potentially enhance returns over the long term6, 7, 8.
What are the main risks associated with frontier markets?
The main risks include higher political and geopolitical risk, regulatory uncertainties, currency volatility, and limited market liquidity3, 4, 5. These factors can lead to unpredictable market movements and make it challenging to manage investments effectively.
How do frontier markets differ from emerging markets?
Frontier markets are considered less developed than emerging markets, with smaller economies, shallower capital markets, and greater investment barriers1, 2. Emerging markets have more mature financial systems, larger market capitalizations, and are generally more integrated into the global economy.