Emerging markets (EM) have been repeatedly pummeled by the prospect of tapering this year, but the sudden outflows and inflows of money that can cause problems for EM stocks don’t have the same impact on relatively illiquid frontier markets. Frontier market (FM) has outperformed EM with gains of 19% so far this year, compared to a net loss of 5% (despite a 14% EM Rally since the summer), but FM has gained so much popularity that it now trades at a slight premium to EM even though analysts expect FM to have a weaker 2014.

Frontier markets are protected by illiquidity

“That the frontier markets are smaller and less liquid than the emerging markets is not a coincidence. All of the frontier markets combined trade just $710m a day (over the last three months), with the GCC accounting for the bulk of the volumes (75%),” writes Citi analyst Maria Gratsova. “The lack of breadth and depth of these markets likely helped shield them from the selling pressure that emerging markets experienced this year.”

You can see the effect of this protection in currencies that are have both been less volatile and depreciated less over the last year.

Frontier Market vs EM currency depreciation

Frontier Market inflows vs. Emerging Market

FM had net inflows of $3.7 billion, considerably stronger than EM over the same period, partly because FM investors are comprised of more local investors and long-term foreign investors than EM and partially due to illiquidity, but this feature makes FM equities more of a defensive asset than people usually imagine. Extremely low correlations also help make FM equities more attractive.

“Often considered by investors to be a favourable characteristic of the frontier markets, correlations have been even lower in 2013 than in prior years. 40-week correlations of FM to global markets are 49%, while EM to global correlations are considerably higher at 78%,” writes Gratsova.

Frontier Market inflows v EM and MSCI FM

FM equities command a 5% premium over EM

“Despite gains of 19% this year, frontier markets are still 47% below their pre-crisis peak, compared to EM 22% below their peak,” write Gratsova, but she warns investors that they shouldn’t expect another year of 19% growth. In fact, in a development that should be familiar from other contexts, rising investor interest has pushed up valuations to the point that value stocks are harder to find.

growing interest in Frontier Market

At this point, FM equities actually command about a 5% premium over EM, even though the premium has historically gone to EM. This reversal makes FM look somewhat expensive, even if it does have more room to recover than either emerging or developed market equities.

Frontier Market vs EM performance 1213

Frontier Market vs EM valuations