The Difference Between Emerging And Frontier Markets

Aggressive investors may decide to invest in the stocks of smaller companies that trade in less-developed, international markets as a way of reaping larger capital gains. These companies are often located in countries with frontier and emerging market economies. However, there are key differences to be aware of between frontier and emerging market economies.

Understanding Emerging Markets

Countries with an emerging market economy used to be referred to as “less economically developed countries” (LEDCs). These are countries that do not currently have the economic strength of countries like the U.S. or Japan but are in the process of becoming a developed economy. Some examples of emerging market economies are India, Mexico, Russia, Pakistan, and Saudi Arabia.

Emerging markets offer greater liquidity and stability than frontier markets. However, some financial analysts believe that certain emerging markets have matured to the point where they move at least somewhat in tandem with the U.S. market. As a result, they fail to provide the level of diversification they once promised. Frontier markets are now filling this gap for long-term investors seeking a return on their capital that is largely uncorrelated with the rest of the global economy.

Understanding Frontier Markets

Frontier markets are less advanced economies in the developing world. A frontier market is less established than an emerging market. Many frontier markets do not have developed stock markets, and while they are smaller, less accessible and riskier than emerging markets, they are still considered viable investments.

However, investors who invest in frontier markets face certain risks, such as political instability, poor liquidity, inadequate regulation, substandard financial reporting, and large currency fluctuations.

Advantages and Disadvantages of Frontier and Emerging Markets

While frontier markets come with some substantial risks, they may also offer the kind of returns that emerging markets once did, especially during the 1990s and early 2000s. The population of the economies that make up the frontier market accounts for approximately one-fifth to one-third of the world’s population and includes several exponentially-growing economies. However, frontier markets still remain a very small slice of the global economy.

Some economists believe that the companies that are part of the frontier market in Africa will experience the next major world economic boom. Regardless of their projected growth, emerging markets can still provide higher returns on capital with less risk and greater liquidity than frontier market holdings, despite their increasing correlation with the U.S. market. Aggressive investors could profit in the long-run by allocating equally into each of these sectors.

Emerging Market Vs. Frontier Market

Let’s now take a look at the difference between the two. These conditions below are meant to be broad, and they may not exactly represent exactly all of the features of any given emerging or frontier market.

Economic Development Level

Emerging markets are more advanced in terms of economic development compared to frontier markets. They have established industries, stronger infrastructure, and more robust financial systems. Countries like China and Brazil are considered emerging markets because they have achieved significant industrialization and integration into the global economy. Frontier markets such as Kenya or Bangladesh are in the earlier stages of economic development.

Market Size and Liquidity

Emerging markets have larger and more liquid capital markets, allowing investors to buy and sell securities easier. For example, stock exchanges in India or Mexico have higher trading volumes and broader investor participation than those in frontier markets. Frontier markets, meanwhile, are characterized by smaller, less liquid markets. There are going to be more liquidity challenges here, making it harder for investors to enter or exit positions without impacting prices. This lower liquidity increases investment risks but may also present opportunities for long-term gains if markets mature over time.

Integration Into the Global Economy

Emerging markets are more integrated into the global financial and trade systems. They typically play important roles in global supply chains and export industries. Frontier markets are less interconnected with the global economy, relying more heavily on local or regional trade.

Political and Regulatory Environments

Very generally speaking, emerging markets tend to have more stable political environments and developed regulatory systems compared to frontier markets. While risks like corruption and political uncertainty can exist anywhere, emerging markets often have institutions that can handle these challenges better.

Risk and Return Profile

For all of these reasons mentioned above, frontier markets typically offer higher risk and higher potential returns compared to emerging markets. There’s just less certainty with frontier markets, where emerging markets have a bit more information about them. Note that depending on the economic condition, it is entirely possible for frontier countries (or equities for companies residing in frontier countries) to outperform emerging countries.

How Investors Can Access These Markets

Several exchange-traded funds (ETFs) and mutual funds invest in emerging markets. There are also a small number of ETFs that focus on frontier markets. Morgan Stanley Capital International offers the iShares MSCI Emerging Markets Index (MSCI), which consists of 26 developing economies, including Brazil, China, Egypt, Greece, India, Mexico, Pakistan, Russia, Saudi Arabia, and South Africa. Morgan Stanley also offers a frontier markets ETF, the iShares MSCI Frontier Markets 100 (FM). Guggenheim offers a broad-based ETF that includes nearly every country classified as part of the frontier market (FRN).

These securities can be analyzed in the same way as any other investment offering. At the same time, investors should thoroughly research the types of risk they would be taking on with each of these instruments. For the most part, investors should be willing to commit their money for long periods of time. Depending upon global economic factors, frontier and emerging markets may not always move in tandem with each other. It’s recommended that investors who seek broad diversification and less risk divide the aggressive portion of their portfolios between these two sectors.

Frontier and Emerging Markets Offer Broad Diversification

Investing in emerging and frontier markets both offer the prospect of higher returns and higher risk, but emerging market economies are more stable and developed than frontier markets. The economies of emerging market countries have achieved a rudimentary level of development, while frontier markets represent the least economically developed nations in the global marketplace. This lack of development provides a level of investment diversification that cannot be duplicated in more mature markets. Both types of markets also carry several types of investment risk, including market, political, and currency risk, as well as the risk of nationalization.

Emerging/Frontier Markets Vs. Developed Market

The following section might feel rehashed from earlier, but there are some differences between the emerging/frontier market and the developed market.

Generally speaking, developed markets, such as the U.S., Germany, and Japan, represent mature economies characterized by high GDP per capita, advanced industrialization, and well-established service sectors. These countries maintain stable economic systems and high productivity levels. In contrast, emerging and frontier markets are in earlier stages of economic development so they’re not nearly as close to full-scale economies.

Financial markets in developed economies are large, well-established, and highly liquid. They’ll have institutions like the NYSE or the London Stock Exchange. Emerging and frontier markets have smaller, less liquid exchanges with fewer listed companies. In the smallest, least advanced countries, some countries may only operate with local, immediate markets.

An overlooked feature of developed markets is their integration into global trade and finance. They often have a part to play in international supply chains, trade agreements, and capital markets. Emerging markets are moderately connected, enjoying growing but limited access to global financial systems and trade networks. Frontier markets are even less integrated, so they may not have any connection at all.

Example of Transitioned Country

A country can transition from a frontier country to an emerging country. One such example is South Korea.

In the 1960s, South Korea was a low-income country heavily reliant on agriculture. Through a combination of export-driven industrialization, government-led economic planning, and investment in education, the country transformed into an industrial powerhouse.

The country also benefited from the rise of global conglomerates like Samsung and Hyundai. Foreign investment and participation in international trade agreements, such as joining the World Trade Organization (WTO) in 1995, further accelerated its development. Today, South Korea is classified as a developed economy with a GDP of $1.73 trillion in 2023 and membership in the OECD.

The Bottom Line

Emerging markets are in the process of rapid growth and industrialization, while frontier markets are even further way in their development process. Frontier markets carry more risk and potential, while emerging markets are one step closer to becoming a developed country.