Frontier markets

When a portfolio manager looks at investing across countries, the first question is how each country actually behaves as a place to do business. The workbook splits the world into three broad tiers, and frontier markets are the smallest, riskiest of the three.

A frontier market is smaller and less developed than an ordinary emerging market. It usually carries even higher political risk, its markets are often illiquid, and the whole opportunity set is small. In exchange for taking on that extra risk, a frontier market can also offer the highest potential return of the three tiers — the classic high-risk, high-return trade-off, just at a more extreme setting than usual.

Section 17.3.9 (Country Risk) sets out the three-tier classification directly, ranking countries by their unique economic, political and business environment:

• Developed Nations (workbook examples: USA, England, Japan, Australia) — the largest, most industrialised, with well-established rule of law, business interests overshadowing politics, and lower growth rates.
• Emerging Markets (workbook examples: China, India, Brazil, Russia) — rapid industrialisation, high economic growth, riskier destinations offering superior investment return, and higher political uncertainty than developed markets.
• Smaller Emerging Markets, also known as Frontier Markets (workbook examples: Botswana, Kuwait, Nigeria, Iran) — better than the least developed countries but a step below ordinary emerging markets, characterised as high risk–high return, with high political risk, and illiquid and small in size.

A country with a better credit rating generally carries lower country risk, but the workbook stresses that a portfolio manager also weighs economic growth, debt and liquidity position, and social parameters to arrive at an overall country-risk view — the credit rating is a starting point, not the whole answer. Despite country risk, the workbook notes that diversification benefits and available risk-mitigation tools continue to draw investors and fund managers toward international investing.

Illustrative, using the workbook's own tier examples. A global PMS mandate of Rs 20,00,00,000 is allocated across the three tiers: Rs 12,00,00,000 (60%) to developed markets (a US/Japan equity basket), Rs 6,00,00,000 (30%) to emerging markets (an India/China/Brazil basket), and Rs 2,00,00,000 (10%) to frontier markets (a Nigeria/Kuwait basket).

In a year of global risk appetite, the frontier sleeve is the standout performer, returning 22% against 9% for developed markets and 14% for emerging markets — earning the client roughly Rs 44,00,000 on a Rs 2,00,00,000 stake, disproportionate to its small allocation.

The following year, a political crisis in the frontier basket's largest holding triggers a 35% fall and a period where the manager cannot exit the position at all for several weeks — illiquidity turning what was a paper loss into a forced, drawn-out one. The developed and emerging sleeves, by contrast, remain tradeable throughout. The frontier allocation delivered exactly the profile the classification predicts: the highest potential return, and the sharpest, least liquid downside.

Chapter 17 (Risk), section 17.3.9 (Country Risk), gives the three-tier table with its own named country examples for each tier. Expect a question that names a country and asks which tier it belongs to, or one listing the characteristics of frontier markets against developed and emerging markets.

• Frontier markets are explicitly the workbook's term for "smaller emerging markets" — not a fourth, separate category alongside developed and emerging, but a sub-tier below ordinary emerging markets.
• The named frontier examples are Botswana, Kuwait, Nigeria and Iran — India, China, Brazil and Russia are the workbook's emerging market examples, not frontier ones. Mixing the two lists is the most common error.
• Higher potential return in a frontier market comes bundled with illiquidity and political risk — a candidate who cites only the return side of frontier markets is answering half the question.
• Credit rating is a useful proxy for country risk but not the whole assessment — the workbook explicitly lists growth, debt, liquidity and social parameters as additional factors a manager weighs.