Oct 7 (Reuters) - After a year of mediocre returns from emerging markets, many investors are searching for yield in so-called frontier markets in hopes that low prices and potential growth will outweigh the risks in little-developed lands.
Often viewed as tomorrow's tigers, nations like Nigeria, Qatar, Bangladesh or Colombia have drawn interest from asset managers looking for well-managed companies serving a growing middle class - a combination with strong potential for profit.
"It really is one of the most interesting asset classes," said Gavin Graham, chief strategy officer at INTEGRIS Pension Management Corp in Toronto. "There are very few markets left that are not correlated to major asset classes. With rates having gone so low, everything moves in one direction. Frontier markets don't."
Graham said every investor who owns international equities should look at boosting exposure to frontier markets, especially since aging emerging market stars like China, India and Brazil have become more correlated to developed nations, nullifying their appeal as high-growth performers.
Since the start of 2012, MSCI's Frontier Market index has risen 20.1 percent, nearly triple the performance of stocks in its emerging market index, which climbed 7.0 percent.
Dividend yield is also above 4 percent, almost double the 2.5 percent for global equities, while typical price-to-earnings ratios are lower, because share prices are relatively cheap.
Frontier companies and countries are also often far less leveraged than those in the developed world, making rising global interest rates less threatening.
"Typically people have been going to emerging markets before they have looked at frontier markets, so they have really been overlooked," said David Kunselman, senior portfolio manager at Mississauga, Ontario-based Excel Funds Management, which specializes in emerging markets.
The potential rewards from frontier markets come with high risks. During the last financial crisis, MSCI's International Frontier market index lost about two-thirds of its value in eight months. And it is still only worth a little more than half of what it was in early 2008.
Excel Funds does not have a frontier fund, but it will, Kunselman said. "We like these countries. To us, the frontier markets are almost emerging markets, 10 years beforehand. They are the next emerging markets."
A new fund would likely be welcomed in what is a relatively illiquid investment sector without a lot of options. One high-profile fund, the Templeton Frontier Markets fund , closed to new investors in June, citing a surge in money.
"While the Templeton Emerging Markets Group does not see any capacity issues within the frontier markets universe, the soft close is a way to best manage the flows coming into the dedicated frontier market portfolios," spokeswoman Sarah Kingdon said in an email.
While the market may be relatively overlooked, a surge of money may inflate prices too quickly and push investors into second-tier companies as they look for new bargains.
Along with some U.S. and European mutual funds in frontier markets, a handful of exchange-traded funds (ETFs), including the BlackRock Frontiers Investment Trust have also invested in the sector.
While the lower costs of ETFs boost their value in developed market assets, that may not work for frontier markets. Graham said paying the fees for active management has paid off in frontier markets, even with management expense ratios (MERs) at about 2.1 percent.
"Even after those MERs, they still manage to beat the (frontier) index" said Graham, whose book "Investing in Frontier Markets: Opportunity, Risk and Role in an Investment Portfolio," co-authored with Al Emid, was released last month.
"With frontier markets, the quality of the information you are getting is not particularly great, so you have to be based there, or at least traveling frequently ... to kick the tires, see the management," Graham said. "Otherwise you risk being seen as the stupid foreigner with a checkbook."
While some investors might balk at investing in nations like Argentina, Egypt or Pakistan, which are strife-ridden and unstable, many asset managers see volatility rather than risk.
Thomas Vester Nielsen, frontier market portfolio manager at Lloyd George Management (LGM), a unit of Bank of Montreal , said the beauty of holding 40 equities in two dozen less-developed countries is that they have no correlation with each other. Problems in Georgia may not touch Cambodia, and strife in Kenya is not likely to affect shares in the United Arab Emirates.
That effectively diversifies a portfolio, a welcome development in a global market in which a default in Europe or a monetary policy shift in the United States can drive down equities, bonds and commodities in one afternoon.
Holdings in LGM's Frontier Markets Strategy portfolio range from Vietnamese milk producer Vinamilk to Nigeria's Guaranty Trust Bank and Senegalese telecom Sonatel .
And given the liquidity question and volatility, a long-term approach is critical.
"Ten years plus. This is what you consider for your retirement funds or kids' college funds," LGM's Vester Nielsen said. "Take a cornerstone of your portfolio and you leave it aside with a long-time horizon, not money you depend on in the short run."