How to invest in frontier markets - if you dare

If you want an investment that will buck the current trends, emerging economies could be for you. But it will be a bumpy ride, and you may just end up losing money in several languages.

When the stock market turns ugly, the quest for 'non-correlated assets' intensifies. A non-correlated asset is fancy Wall Street talk for something that doesn't move lock-step with the overall market. When the market falls, a non-correlated asset might actually rise, or at least hold its own better than the market.

Gold is a classic example. Its price tends to rise during times of stock market distress. But very few investments can rival gold's long history of non-correlation. Imposters abound. The imposters might move independently of the overall market for months or years at a time, thereby creating the impression that they are non-correlated. But when the markets really turn nasty, investors often learn that their "non-correlated" asset tumbles just as sharply as an S&P 500 Index fund.

However, some investors think they've found a reliable new non-correlated asset: frontier markets. Merrill Lynch recently created an index not only to track them, but for investors to buy and sell them.

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Frontier markets include Pakistan, Kuwait, the United Arab Emirates (UAE) and other markets throughout Africa and the Middle East. They also include Vietnam, Kazakhstan, Cyprus and others. They are individually too small for institutions to invest in, but cobble them together in a new index that allows you to buy and sell the basket and well, then you have something.

Merrill Lynch's new Frontier Index tracks the 50 largest companies in 17 frontier markets. Even so, the market value of all these companies combined is only about $330 billion - or about that of General Electric. Right now, the index heavily tilts toward the Middle East, with 50% of the index in the region. Asia is the second largest component, with 23%, followed by Europe at 14% and Africa at 13%.

As for industry groups, banks usually are among the biggest companies in any emerging market. So banks and financial service companies represent about 65% of the index. Oil and gas is the next largest sector, weighing in at 13%. As far as countries go, the top three are the UAE (23%), Kuwait (18%) and Pakistan (14%).

So far, these frontier markets have lived up to their advance billing of not following the broader markets. Since Sept. 30, for example, the frontier markets actually gained 31% while the broader market lost ground. Merrill Lynch backtested the index several years and found that between February 2000-December 2007, the index return's correlation with the S&P 500 was only 32%. Basically, that means that about two-thirds of the time, the frontier markets zigged while the S&P 500 zagged.

I love the idea of frontier investing, because I'm an optimist when it comes to global trade and booming overseas markets. Maybe it's my globe-trotting that's skewed my view. But when I travel overseas, I see great opportunity. I see people building businesses. I see the impact of global market forces on local energy, food and resource markets. I see the world getting smaller.

I'm long-term bullish on markets such as the UAE, Kuwait, Vietnam and others. But I also realize that the ride in some of these markets will be absolutely gut-wrenching. Just look at Vietnam.

The Vietnamese economy is growing somewhere between 7-9% per year. It is a cheaper place to do business than many other parts of Asia. Hence, Vietnam continues to attract a strong flow of investment.

While I liked what I saw going on there, I found no direct investment ideas for us. The market is just too small and illiquid. Heck, before March 2002, the market traded only on alternate days. Moreover, as with most of these frontier markets, Vietnam suffers from poor disclosures and low transparency. When you invest here, you're really not sure what you're getting.

I remember listening to Carlo Cannell, a very good investor at Cannell Capital, talk about his trip to Vietnam and his investments there. This was back in May 2007. The theme was investing in the dark. In Vietnam, he basically made many blind bets on lots of companies, figuring enough of them would work out.

But the market has tanked since then.

Perspective, though, is everything in markets. That chart looks nasty, with a near 50% drop from the high in less than a year. But as recently as July 2005, the index was only 250. You'd still have more than doubled your money in less than three years. In 2000, it was only 100. Investors are still up sixfold from 2000, which is a lot better than an investment in the S&P 500 Index. And that's really the key to the whole frontier market idea. As an investor, what's most important is what happens over the years.

I'm skeptical of the idea of frontier markets as an 'non-correlated asset' for all seasons. Links between these small markets and their bigger brothers are probably stronger now than in the past. Vietnam, for example, depends heavily on foreign investment. Vietnam's currency, the dong, is still linked with the dollar. So we have to be careful in taking the past and saying the future will work the same way.

On their own merits, as growing economies, I like frontier markets for the long haul. Unfortunately, only institutions can buy Merrill's index for now. But individual investors can still invest in frontier markets through mutual funds. The recently launched T. Rowe Africa & Middle East Fund (TRAMX) is one. Just be sure you can stomach the major gyrations that come with working the frontier of investing.

I'm also watching the activities of individual companies in these markets. This may be a safer way to go - a back door into the frontier markets, you might say. Many of our companies are in these markets one way or another. Take Hutchison Telecom (NYSE:HTX), for example. It's got businesses in Vietnam, Ghana, Sri Lanka and Indonesia.

In any case, I think frontier markets will have a bigger role to play in portfolios in the years ahead, whether they are truly non-correlated or not. Worst case, you'll lose money in many different languages, not just English.

By Chris Mayer for Whiskey and Gunpowder