It takes just one word to make investors shudder about the risks of frontier markets: Argentina.
The country, once a darling emerging market, was demoted to "frontier" status three years ago by MSCI Inc., whose frontier-market indices are used by investment houses and financial institutions.
MSCI didn't like the country's capital controls. It didn't help that President Cristina Fernandez de Kirchner nationalized pension funds and later tried to fire the country's head of the central bank.
Politics in Argentina "are horrible," acknowledges Lawrence Speidell, the chief investment officer of California-based Frontier Market Asset Management LLC, which specializes in frontier markets. Nevertheless, his firm has an investment in an Argentine bank.
"We're not adverse to investing in markets where there may be an unsavoury regime in place but where there's hope that the future will be better," Mr. Speidell says. That means investments in Zimbabwe ("Mr. Mugabe won't live forever," he says) and Venezuela (even though "it has essentially obliterated its market").
Mr. Speidell sees frontier markets – defined by their low-market capitalization and lack of liquidity – as great opportunities, made even better because so many investors are afraid of them.
It's a view shared by David Kunselman, senior portfolio manager at Mississauga-based Excel Funds Management Inc. Frontier markets are still trading at 40 per cent below what they were in the days before the August of 2008 stock crisis, he says. "These are markets that have been ignored," he adds.
Excel Funds specializes in emerging markets, but Mr. Kunselman says it watches frontier markets with interest. What it sees is "a very positive story" of great fundamentals – low valuations, high dividend yields and high growth ahead.
Stephen Lingard agrees. He is the director of research for Franklin Templeton's multiasset strategies group, which managed $27.4-billion as of Sept. 30. Of that, 1.5 per cent is invested in frontier markets, which he says doesn't sound like a lot but the fund has to move carefully in markets that aren't that liquid.
"We love the overall asset class," he says. "If you put up with a little less liquidity … you get access to higher growth rates at cheaper valuations than you can either in emerging markets or developed markets."
Mr. Kunselman says many investors see frontier markets, which include countries from the Middle East, as heavy oil markets, but that isn't really the case. Financial companies represent almost half of the MSCI frontiers market index, he says.
And banks in these countries are not like those in Western countries, Mr. Speidell points out. There is no derivatives trading or large mergers and acquisitions – these banks just take deposits and make loans, often paying little on deposits but charging a lot for loans. They fall into a category that Mr. Speidell looks for – "companies that benefit from a rising middle class."
Mr. Kunselman agrees that the rising middle class, along with higher gross domestic product per capita numbers, are fundamental themes that should drive investment to frontier markets. "It's all about benefiting form the increasing amount of credit growth and consumer purchases," he says.
But he also points to emerging and frontier markets as a way for Canadians to diversify. "People here have 70 per cent of their money invested in Canada, and if Canada doesn't perform well over the next 10 years, people's retirements could be very disappointing," he says.
Frontier markets are negatively correlated with the S&P/TSX, he adds, which means that when the market here goes up, the markets there may go down, and vice versa.
"That means if an investor were to buy [into frontier markets] and diversify their portfolio, it can actually reduce the overall portfolio risk."
As well, Mr. Kunselman argues that because the Canadian dollar is so high, it's a good time to go outside of Canada to invest.
But Matt Barasch, vice-president of portfolio management at RBC Wealth Management, says investors have to understand that there is a big risk in investing in frontier markets, and most of that has to do with politics. Many of the countries understand that there is a "Western way" of doing things economically, he says, but "politically they don't act that way."
He cites as an example countries that tie their currencies to the U.S. dollar. "You saw this with Argentina in the early 2000s – it's in their best interest until all of a sudden it isn't in their best interest any more, and all of a sudden you get this massive re-evaluation of the currency – overnight you've lost 80 per cent of your value to that."
Mr. Barasch suggests an alternative to investing directly in high-risk countries is to invest in companies that do business in those countries – such as Canadian mining companies that have properties there or multinationals such as Coca-Cola, which sell everywhere.
Mr. Speidell and Mr. Kunselman disagree.
"We're trying to make a case for a Canadian investor to look outside of just BCE or TransCanada," Mr. Kunselman says. "They already own boatloads of that."
Says Mr. Speidell: "I think the main obstacle is our own mental image of these places because of the media, which tend to highlight the bad things that go on. But of course, if you depend on the media, you'd be afraid to cross the border into the United States."