Diversification is a strategy all financial advisors have come to rely upon to protect their clients’ investment assets. The theory is that all three of the core asset classes – cash, debt and equities – could not decline at the same time or pace, and that trying to time market ups and downs is largely a folly.

In turn, that general notion has nurtured an even more sophisticated approach, in which portfolios often are diversified geographically, by investment style, by sector and by a host of other, narrowing approaches. One popular evolution is the inclusion of “emerging markets,” which are countries with burgeoning economic potential but perhaps hampered by inefficient markets, lack of liquidity and other constraints, yet representing strong promise of growth.

In an attempt to fine-tune the whole diversification strategy, the authors of Investing in Frontier Markets: Opportunity, Risk and Role in an Investment Portfolio suggest that advisors and their clients take a serious look at “frontier markets,” which are countries that do not yet qualify for emerging-market status.

Gavin Graham, an expert on emerging markets, and Al Emid, a financial journalist, argue that the economies of these frontier countries are at a stage of development comparable to where the emerging markets were 10 to 15 years ago, and that the frontier countries will follow similar patterns of economic development – potentially making them very rewarding places to invest.

In the authors’ view, it is not the high rates of gross domestic product growth that make these smaller markets attractive; rather, it’s their low price/earnings ratio of 10.3 and dividend yield of 4.1% (as of September 2012), which match where the emerging markets were at the beginning of the previous decade.

Reward should be commensurate with risk, and when it comes to less developed countries or regions, we tend to assume greater volatility. Here, Graham and Emid remind us that volatility is not the same as risk by noting that frontier markets are not highly correlated with other major stock markets or the other emerging and frontier markets. Thus, although frontier markets are volatile, adding them to a portfolio will reduce its overall volatility. (The authors also note that volatility in emerging and frontier markets has been falling gradually over the past decade, while volatility in developed markets has been rising – although emerging and frontier markets are still more volatile.)

So, what are the implications for you in considering frontier markets as appropriate investment options for some clients?

First, I would suggest that an appreciation of the continuum of economic evolution that almost all countries follow – from “exotic frontier” to “frontier” to” emerging” to “developed” status – will be important. You will need to explain this to your clients, particularly when you begin identifying specific frontier country investments you want to include in their portfolios. Names such as Botswana, Kazakhstan, Serbia and Kuwait may not immediately conjure up images of great places to put their money.

Second, develop a good understanding of what’s really going on these countries. It’s easy to be influenced by the evening news and assume that an entire region or country is in a complete dysfunctional state or chaos. The authors have done a good job of looking beyond the media reporting to help us avoid generalizations about a region such as the Middle East and recognize that some countries in the region, such as the United Arab Emirates, offer relatively safe havens and promising investments.

Third, hone your speech about the importance of your client having a long-term perspective on investing. For instance, in countries with a large percentage of their population still living in rural areas, high birth rates and a young population, a much longer-term horizon is required for the potential to be realized.

Fourth, generally accept that you will have to spend more time and effort in educating your clients about the investment potential of frontier markets than with more traditional investments. In fact, it might make sense to start less experienced investors off with emerging-market investments rather than frontier-market investment, because the former category can be accessed through more traditional and familiar investment vehicles, such as mutual funds.

Finally, explore the investment vehicles available to you to access frontier markets, such as exchange-traded funds, regional funds, single-country funds, individual equities, American or global depository receipts, and global frontier market funds.

There are two things I really liked about this book: it’s relatively easy to read and the authors have no objective other than to educate and inform.

Investing in Frontier Markets: Opportunity, Risk and Role in an Investment Portfolio

by Gavin Graham and Al Emid,

John Wiley & Sons Inc.; 256 pages, $125

* * *

© 2013 Investment Executive. All rights reserved.