Ten years ago, global investors rarely invested in China and India. Today, global investors who aren't invested in these emerging giants feel like they are missing out on the hottest money-making opportunity around. Yet, as India and China have become plain vanilla for global investors, there are a group of countries that attract the true Indiana Jones' of the investment world. The International Finance Corporation (IFC) calls these countries "frontier markets."

The IFC first cobbled together the S&P/IFC Frontier Index over a decade ago. The index measures the performance of stocks of 22 countries not quite on the "A list" of global tourist -- or investment -- destinations. They include Bangladesh, Botswana, Ghana and Ecuador. But those who dared to tread where others feared to invest reaped big profits. The Frontier Index has returned an average of 37% over the past 5 years, compared with an average 25% for the Morgan Stanley Emerging Markets Index. That means that those brave enough to invest in frontier markets quintupled the returns of the S&P 500 over the same period.

There are some big winners -- as well as losers. Since March 2003, Ukraine has risen by 570%, in dollar terms, Kenya by 279% and Bangladesh by 79%. This year, Namibia was the top performer by posting a 126% return, while Tunisia declined 8%. And Saudi Arabia's market plummeted a whopping 50% in 2006.

Frontier markets are tiny. With a total market capitalization of about $40 billion, the whole sector is worth less than 20% of the current value of China's ICBC bank. Yet such numbers are deceptive. When I started covering the Russian stock market in 1996, its total market capitalization was about $30 billion. Ten years later, Russia's market capitalization is approaching $1 trillion. Five years ago, GE had a larger market capitalization than the entire emerging markets universe. Today, a single emerging markets company, Russia's Gazprom, is nipping at GE's heels.

Impressed by these results, Acadian Asset Management is launching a new "frontier markets" fund early next year, based on the S&P/IFC frontier markets index. The company's investment case? Frontier countries are following the path to becoming successful developing countries boasting viable stock exchanges and big returns for investors.

From "Frontier" to "Emerging" To "Developed" Markets

Definitions of 'frontier', 'emerging' and 'developed' markets vary in the eyes of the beholder. I recently heard a reporter on CNBC describe Japan, the world's second largest economy and the same country that was eating the U.S.'s economic lunch in the 1980s, as an "emerging market."

Better to focus on the process than definitions. Fifteen years ago, Poland and Hungary were frontier markets. Today, both are members of the European Union. Their companies adhere to international accounting standards. Their leading companies have dollar-denominated shares that trade in London or New York. They are covered by Wall Street analysts.

Frontier markets can emerge surprisingly quickly. Consider that the S&P/IFC Frontier Index includes Bulgaria, Estonia, Latvia, Lithuania, Romania, Slovakia and Slovenia. With accession of Bulgaria and Romania to the EU on January 1, 2007, all are now members of Europe's Rich Man's Club -- and arguably have leapfrogged into "developed" status.

Frontier Markets: A Familiar Pattern

The best rule of thumb for investing in frontier markets is summed up by master investor (and former London Junto presenter) Nils Taube: "Use your eyes and plagiarize." Look at the way companies and trends unfolded in the U.S. and Europe, and bet on similar trends in frontier countries. Successful countries take a well trodden path from "frontier" to "developed."

Vietnam offers a good case study of a hot frontier market. Added to the S&P/IFC Frontier Index only a month ago, the Vietnam Stock Exchange in Ho Chi Minh City doubled in value last year. Foreign investors spent $123 million buying Vietnamese stocks over the past three months and they now own about 31% of the market. Investors have raised $1.8 billion to invest in Vietnam ahead of a privatization program next year, which will include eight $1 billion listings. Vietnam is on its way.

Frontier Markets: The Risks

It's easy to get entranced by the high returns of fast growth markets. But no successful investors have escaped without suffering battle scars. Here are some of the things to watch.

First, the "boom bust" cycle is exaggerated in frontier markets. The highs are a lot higher and the lows are a lot lower. In 2005, Gulf equity markets were the best-performing markets in the world. In 2006, the Saudi market halved. Look for a similar end to the mania currently gripping China Bulls in Shanghai.

Second, Frontier markets are tiny and illiquid. Sometimes as little as $50,000 of shares trade daily. I learned that hard lesson ten years ago when I bought second-tier Russian oil companies an incredibly low prices. I bought them easily enough. But I could not find a buyer for them.

Third, Frontier markets are attractive only when they are cheap. Unless you get a bargain, you won't get rewarded for the risk you're taking. Few markets have escaped the scrutiny of Argus-eyed hedge funds trawling the globe for undiscovered value plays. Today's favorite frontier market Vietnam already trades at a P/E of 26 on 2006 earnings. That's a 25%+ premium to the S&P 500.

Finally, there's always the risk that the frontier markets won't grow into developed markets. Central Europe had a rich man's club to aspire to in the form of the EU. That forced it to get its economic act together. Latin American markets don't have that carrot.

Frontier markets aren't for average investors. But you can expect to be rewarded for the bumpy ride.

Sincerely,

Nicholas A. Vardy
Editor, The Global Guru

P.S. Investing in companies based in former frontier markets have produced some of the biggest money makers for my subscribers at Global Bull Market Alert. Our most recent China pick soared over 80% in the past three months and option investors have locked in gains of over 525%. To find out the name of this big winner, get a free, 60-day trial subscription to Global Bull Market Alert today.

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