Portfolio Ideas:Consider frontier markets too

Earlier, in our columns, we had discussed why you should consider investing in global markets, especially the US market. In this article, we extend our discussion on global investments to frontier markets.

In the pecking order for global investments, you have the developed markets, the emerging markets and then the frontier markets. Frontier markets are different from emerging markets in terms of the size and the structure of the financial markets. For instance, frontier markets have fewer liquid and tradeable securities and highly restrictive foreign participation in their equity market. In some cases, these markets are characterised by political instability in their home countries.

These markets are highly risky. But the positive aspect is that they have weak relationship with the developed markets, quite unlike emerging markets. So, if the US market crashes, it is highly likely that an emerging market, such as India, will decline by a similar magnitude. But securities in Vietnam or Croatia may not decline just as much. The reason is simple. Frontier markets and their economies are not yet closely integrated with global financial markets.

While diversification is not the primary reason, higher returns can present a case for investing in frontier markets. The best way to invest in these markets is to buy frontier market ETFs.

So, how do frontier market ETFs fit into your portfolio? Your core portfolio should contain home-market ETFs and mutual funds created through a monthly systematic investment plan.

If you are pursuing a goal that requires you to incur lumpy expenditure in foreign currency at a later date, then you should invest in ETFs traded on US assets. For instance, if you want to send your son or daughter for higher education in the US, you could invest in ETFs relating to US inflation or its education sector.

Inflation hedge ETFs, for instance, generate returns if expected inflation increases. These ETFs buy Treasury Inflation Protection Securities (TIPS) and short nominal-coupon Treasury Securities of the same maturity.

Such US-based ETFs form part of your core portfolio because you are buying them to achieve your life goal. Some exotic products, such as ETFs that offer you returns on the US master limited partnerships index can be part of your satellite portfolio. But such alternative ETFs are exceptions.

Your investments in frontier market ETFs necessarily form part of your satellite portfolio. Why? The primary objective of buying these products is to enhance your portfolio returns. And importantly, these ETFs do not help you meet your life goals. Remember, even if you have liabilities (lumpy future expenditure or goals) in a frontier-market currency, it is better to invest in US-dollar denominated assets and then convert the investment into the currency in which you have to incur the expenditure.

This brings us to an important point. You should not invest more than 10 per cent of your total portfolio in frontier market ETFs. If you already have gold ETFs in your portfolio, ensure that gold and frontier market ETFs together do not cross more than 15 per cent of your total portfolio. Why? These investments are highly risky. Do not expose too much of your portfolio to such high-risk assets.

The writer is the founder of Navera Consulting. Feedback may be sent to portfolioideas@thehindu.co.in

COMMENT NOW