6 areas of caution with frontier market investments

On September 11, 2014, the Financial Industry Regulatory Authority issued an investor alert with regard to investing in frontier markets. Alerts like this are issued by FINRA to apprise investors of the risks of various types of investments. In this case, FINRA is concerned that investors not overlook the substantial risks of investing in frontier markets.

Frontier markets include countries like Lebanon, Nigeria, Vietnam, Slovenia and Argentina. Investing in frontier markets is more risky than investing in other international asset classes. In fact, the frontier markets asset class is probably the riskiest available to mutual fund and exchange-traded fund investors. It is one step beyond international emerging markets in terms of volatility.

Investors in frontier markets should realize that these markets tend to be illiquid, lightly traded, volatile, and subject to manipulation and fraud. In the alert, FINRA advised that “the legal, financial accounting and regulatory infrastructure of frontier markets may be weaker or less developed, and political stability may be more of a concern.” FINRA issued the following six guidelines when considering an investment in frontier markets:

1. Know which frontier markets a fund invests in. Risk factors vary by country — and no two countries share identical risk elements. Read the fund's prospectus to determine whether you are buying a fund that is, or may become, broadly diversified across many frontier markets, or that is narrowly invested in only a few frontier markets, sectors or a single region or country.

2. Monitor changes in indexes. If your employees are investing in a frontier ETF or index mutual fund, make sure they know and understand the index that the fund tracks and also the components of that index. Be aware that the components or “constituents” of an index can change, potentially affecting the return of the fund. For example, components of the MSCI Frontier 100 Index are undergoing changes after Qatar and the United Arab Emirates — which accounted for more than 30% of the value of the MSCI index — were reclassified from “frontier” to “emerging” markets.

3. Geopolitical and currency risks are real. Be aware that some frontier markets are located in parts of the world with unstable political or market environments. Regional conflict, civil unrest and regime change are all significant risk factors, as is currency risk.

4. Costs and fees can be high. Frontier fund costs and fees can be higher than their emerging market peers, and significantly higher than diversified domestic and international funds.

5. Research the fund manager. Understanding frontier markets and managing investments is a specialized skill. Research the fund manager’s professional experience, including fund management tenure and performance record.

6. Limited performance history. Frontier funds are relatively new and most have limited performance histories.

Robert C. Lawton is president of Lawton Retirement Plan Consultants, LLC, an RIA firm helping retirement plan sponsors with their investment, fiduciary, employee education and compliance responsibilities. He may be contacted at bob@lawtonrpc.com or 414.828.4015.