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Frontier markets: Investors go west ... east, south and north

The frontier has always represented opportunity for Americans. Opportunity … and risk.

On the investing landscape, frontier markets can provide the same leading — and sometimes bleeding — edge to investors looking for high-risk/-return scenarios.

These are the markets not yet big enough to qualify as emerging markets. Research firm MSCI includes 24 countries in its MSCI Frontier Markets index, ranging from Argentina (a former emerging market) and Nigeria to Kuwait and Kazakhstan. They generally have a lot of political risk; can often be vulnerable to commodity prices, cultural and environmental issues; and typically have very thin capital markets. They also have great prospects for growth.

If you have long-term investment horizon and can deal with a lot of volatility, frontier market funds can offer some potentially big returns, financial experts explain.

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Stephen Stickler | Getty Images

"In a world where growth is hard to come by in … developed [countries], there's a big incentive to invest in frontier markets," said Pradipta Chakrabortty, portfolio manager for the Harding Loevner Frontier Emerging Markets Fund. "The growth is in these markets, and the earnings growth potential of high-quality companies in them is huge."

Of the growing number of mutual funds focused on these pre-emerging markets, Chakrabortty manages one of the more prominent ones. Lipper tracks 20 such funds managing roughly $5 billion in assets. The Harding Loevner fund manages just over $500 million.

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The investment story for putting money into frontier markets is straightforward.

They present the same opportunity that emerging markets such as China, Brazil and India presented 20 years ago: high economic growth, companies with strong competitive positions in relatively insulated markets and limited awareness in the global investment community.

"All the attention focused on China and India over the last two decades has been well deserved, but this region warrants attention, as well," said Mark Decker, founder of institutional broker Decker & Co.

"If you believe in the long-term story that smaller nations will continue to grow and develop deeper capital markets, it makes sense to get in early. But it can be a bumpy ride." -Jeff Tjornehoj, head of Americas research at Lipper

Decker has been focused on Southeast Asian frontier markets that he believes will continue to have near-double-digit economic growth for the foreseeable future. Based in Vietnam, he provides on-the-ground research on companies and deals in 11 ASEAN (Association of Southeast Asian Nations) markets for U.S. mutual funds investing in frontier markets.

"You can feel the buzz here," he said. "There's nothing like the growth in Southeast Asia anywhere else in the world."

Many argue that the generally illiquid and often economically insulated markets are less correlated to developed markets than emerging economies, but frontier markets have followed emerging markets down over the last several months, with the Chinese yuan devaluation and the volatility of oil prices being big factors.

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The MSCI Frontier Markets Index, which includes 124 listed securities representing about 85 percent of the market capitalization of 24 frontier markets, was down 11 percent through August this year and down over 21 percent in the last 12 months.

While frontier markets tend to be less susceptible to global equity flows than bigger emerging markets, they can and do suffer large drawdowns in times of high volatility. The MSCI Frontier Markets Index had a maximum drawdown of 66 percent during the financial crisis, compared to 58 percent for the emerging markets and 49 percent in the U.S.

"Some of these markets are remarkably small," explained Jeff Tjornehoj, head of Americas research at Lipper. "They can have a lot of volatility because of the lack of liquidity."

He added, "If you believe in the long-term story that smaller nations will continue to grow and develop deeper capital markets, it makes sense to get in early. But it can be a bumpy ride."

It also doesn't come cheap. The largest fund in the category — the Wasatch Frontier Emerging Small Countries Fund, which manages more than $1 billion in assets — has a total expense ratio of 2.24 percent, according to Lipper data, and most of the other funds in the category sport expense ratios over 1.5 percent.

The iShares MSCI Frontier 100 ETF costs 0.79 percent, but Tjornehoj suggests paying up for active management. "You want somebody engaged and with their ear to the ground in these markets," he said.

Chakrabortty at Harding Loevner keeps his fund well diversified to reduce his exposure to individual markets, currently investing in 30 different countries (some not in the MSCI index). He is constantly assessing political and economic risks in individual countries and makes tactical decisions based on his readings.

"Elections are red flags for us," he said. "They make us dig a little deeper into potential political risks."

Currency risk is also a major factor. Chakrabortty is underweight Nigeria, for example, which has a near-14 percent weighting in the MSCI index. The country just came through an election without much violence, as many expected, but the new president, Muhammadu Buhari, appears intent on resisting a devaluation of the Nigerian currency despite the country's big exposure to oil prices.

Chakrabortty thinks it's an unwinnable battle and expects a devaluation in the near future. "We're bullish on Nigeria long term, but we're underweight in the short term," he said.

While many of these markets may fall still further, Chakrabortty sees the recent pullbacks as a chance to buy into good companies with strong positions in their markets at much better prices.

"The long-term growth prospects of these countries and the companies operating in them hasn't changed," he said. "The short-term corrections are opportunities to buy high-quality names that are often out of reach."

— By Andrew Osterland, special to CNBC.com