Are global investors, enamoured of emerging and frontier markets, ignoring the many negatives?

1. The recent rise of Frontier Markets has been due to a commodities and consumer credit boom. As China slows and the Fed tightens, both are going away.

2. Frontier markets are relationship based (as opposed to rule based) systems. They have economically inefficient legal infrastructures that lead to asymmetries of information and distort allocations of capital. This is a recipe for boom and busts. Investors in Brazil had to wait more than 20 years after its bust for it to regain respectable growth.

3. It is very difficult for retail investors to find vehicles to invest in Frontier Markets. For example one of the best recently performing markets has been the UAE which has increased 28%. The safest way to invest would be the DFM General Market Vectors Gulf States Index ETF (MES). But it is small ($11 million) and represents other Gulf States. It was up only 16%. Other markets that did well this year include: Argentina 27%, Nigeria 19%, Kenya 15% and Botswana 16%. But none have their own ETF.

4. These markets (and the BRIC markets) are usually concentrated in a few companies that are often state owned. These companies are invariably financial or commodities. They often reflect global not local conditions.

5. The corporate governance is dreadful. The regulatory regimes are appalling. They are all exceptionally corrupt. If the economy is growing, that means that someone is making money, but it may not be investors.

6. The demographic advantage of hoards of young people is more of a disadvantage than advantage. Many of these countries’ sole export are commodities. When it is easier for the elite to extract profits from the ground rather than the economy, there is little incentive to create the institutions for sustained growth. This leads to a plethora of ill educated, unemployed, frustrated and angry young men who are a threat to social stability.

7. These markets are very volatile and subject to every sort of financial abuse from insider trading to outright fraud. If you are very lucky you might catch an updraft, but don’t count on it being sustained.

The first emerging markets boom occurred in 1824. After the Napoleonic wars interest on British government bonds (consuls) fell to 3%. As a result there was a search for yield. Investors bought into the bonds of newly created countries like Mexico, Brazil, Columbia and Guatemala. These bonds were yielding about 6%. By 1826 the market value of Columbia bonds had fallen 50%.
 

(William Gamble is president of Emerging Market Strategies. An international lawyer and economist, he developed his theories beginning with his first-hand experience and business dealings in the Russia starting in 1993. Mr Gamble holds two graduate law degrees. He was educated at Institute D'Etudes Politique, Trinity College, University of Miami School of Law, and University of Virginia Darden Graduate School of Business Administration. He was a member of the bar in three states, over four different federal courts and has spoken four languages.)