Frontier markets can be used to help lower risk in your portfolio.

That might sound like a counterintuitive statement. After all, frontier markets like Sri Lanka or Kenya are often referred to as “pre-emerging markets” and they can exhibit significant country-specific risk. Compared with emerging markets, frontier markets tend to have more concentrated economies, are generally subject to more political risk and are more exposed to commodity price movements.

But that doesn’t tell the whole story when it comes to frontier markets, emerging markets and risk. The relationship between the three has changed as emerging economies have become more developed, and new countries and companies have been added to the list of frontier markets. [Frontier Market ETFs]

First, emerging economies have become more correlated with each other and also more correlated with developed economies. In the last 10 years, the MSCI Emerging Markets Index has had a correlation of around 90% with the MSCI Developed Markets Index, compared with around 70% in the 10 years prior[1]. Emerging markets do offer investors the opportunity to participate in the long-term trend of consumer growth in the developing world. But it’s important to note that they are also not as diversifying to a total portfolio as they used to be.

In contrast, frontier markets have remained reasonably different from one another. Their economies are not as integrated into global markets, and they are subject to a wide range of idiosyncratic local economic and political dynamics. The result is that correlation across frontier markets remains generally low, allowing them to diversify each other reasonably well. This in turn creates a level of overall risk that is surprisingly lower than that of the emerging market index.

For instance, since January of 2008, the MSCI Frontier Index had a realized risk of 23.6% compared with 29.7% for the Emerging Markets Index[2]. This is a notably low number considering that the MSCI Developed Markets Index over the same period of time had a realized risk that was not much lower at 21.4%.

In addition, the overall correlation between frontier markets and developed markets is lower than the correlation of emerging markets with developed markets. Since January 2008, the correlation between the MSCI Emerging Markets Index and the MSCI Developed Markets Index was 92% compared with 78% for the Frontier Markets Index. In other words, an allocation to frontier markets would have offered some diversification to the total equity portfolio due to its lower overall risk and its lower correlation properties.

Consider that since 2008 a 10%/90% mix of Emerging Markets and Developed Markets would have delivered risk of 22% whereas a 10%/90% mix of Frontier Markets and Developed Markets would have delivered risk of 21% — a full one percentage point less.

It’s important to remember that frontier market event risk, both on the policy and political fronts, is higher than the average emerging or developed market. But a small allocation to frontier markets can provide investors with access to the early development in these economies while potentially offering the benefit of diversification.

[1] Data is from Bloomberg. Daily index levels are collected for each index and monthly returns are computed from September 1992 to September 2012.
[2] Note that 2008 is the first full year for which the MSCI Frontier Index has a “live” track record.

Daniel Morillo, PhD, is the iShares Head of Investment Research.