What are emerging and frontier markets?

The risk spectrum runs from developed (least risky) to emerging to frontier (most risky).

What makes a country an emerging market?

• Size and liquidity of capital markets
• Governance standards
• Political stability/instability
• Accessibility of the stock market for foreign investors

While the economies of India and China may be larger and faster growing than in the West, their capital markets are seen as less advanced than Europe, North America and Japan.

For investors, packing the 23 countries from Brazil to the United Arab Emirates into a convenient package is within reach. It helps people know what they are buying – and it also helps fund management firms market and measure fund performance.

What are frontier markets?

Moving past risk and sophistication status takes us to frontier markets, which, as the name suggests, are on the verge of becoming emerging markets. Frontier market Vietnam, for example, has been talked about for years as a candidate for promotion and has set its sights on becoming an EM by 2025. Examples of frontier markets include Nigeria, Sri Lanka.

For liquidity reasons for this, as capital flows in greater quantities to countries designated as “emerging markets”; and for investors, this helps because hedge funds and trusts are fewer in number, more niche and less liquid.

Some of the border countries may seem confusing to investors: Iceland, with a higher GDP than the UK, is on the border list, as is Croatia, a new member of the eurozone. Although there is often a correlation between a country’s status and economic development, sometimes this correlation is not obvious. In Iceland’s case, its capital market is much smaller than, say, the UK or Germany, with 27 companies listed on Nasdaq Iceland. In this case, being a frontier market is not a value judgment on a country’s economic power.

The issue of emerging and frontier markets

• China dominates and has dragged EM down
• Alternative power bases are developing as the world changes
• The index is focused on China and India
• There are anomalies: Iceland and Croatia
• Performance lagged behind developed markets
• Emerging markets often fall with developing markets
• ESG investors may struggle with the inclusion of countries

China’s stock markets have struggled to match the US’s performance in 2020, and that’s a problem as nearly 25% of the index is weighted towards the country. A good year for China flatters EM performance and vice versa. Active fund managers may choose to weight these countries differently, but passive products rely on China as the engine of EM. India outperformed, and in May this year it received a larger share.

The other issue is that of shifting “spheres of influence” in the developing world: Russia’s invasion of Ukraine has realigned loyalties, while Saudi Arabia – a new 2019 entrant to the EM world – now has huge political influence global and sports. even as the West’s dependence on oil declines.

Hitting the wall BRIC

Fund companies used to sell “BRICS” funds as a sort of turbocharged EM play, but performance has disappointed and Russia’s 2022 invasion of Ukraine has wiped out EM indices. The idea of ​​a rival power base was considered redundant until South Africa, a member of another power bloc, the G20, proposed some additions to revive the idea. Last year, in addition to Brazil, Russia, India, China and South Africa, the world received five new BRICS (see below). Turkiye, a small component of the EM index, is proposed as the sixth.

• Iran
• United Arab Emirates
• Saudi Arabia
• Ethiopia
• Egypt

A good proportion of these countries are involved, directly or otherwise, in the world’s biggest conflicts and are subject to Western sanctions. So there is an ethical filter that some investors will apply to narrow the “emerging markets” basket as well.

Ways to approach emerging markets

Where does this leave investors, who might be bullish on Brazil but cold on China?

One approach is to try to “pick the winner”: single-country funds are popular and liquid, but can be risky if there is a crisis, a common feature of EM investing. Turkey, for example, has a booming economy in 2024, but had an attempted military coup in 2016 and has periodic currency crises.

Meanwhile, emerging or frontier markets funds would theoretically be more diversified: a crisis in one country could be offset by a stunning performance in another. In reality, contagion crises occur, pulling many countries together – and this is the danger of regional funds. Latin America, currently a “hot” region due to commodity demand, has had many boom and bust cycles.

If an investor goes the fund route, it’s worth taking a closer look at which countries the fund invests in. In addition to the country focus, there is also a fair amount of company concentration, with Taiwan Semiconductor Manufacturing (2330), China’s Tencent ( 00700 ) and Alibaba ( BABA ) and South Korea’s Samsung ( 005930 ) as key names in many portfolios . This is where the “emerging market” label may no longer really work: Samsung, a global electronics brand, is twice the size of Britain’s biggest company, AstraZeneca ( AZN ).