There are a number of reasons for the rush of interest in frontiers. Index investors are seeking the diversity and significantly lower correlation against emerging and developed segments of their portfolios, where diversification effects are beginning to blur. Investors who have found emerging markets a safe harbor in the wake of the Western credit crisis are emboldened and are venturing further afield into the frontier. The same is true for investors seeking diversification in some of the frontier countries that have commodity-based economies. Other investors are pursuing secular growth in oil-rich Middle Eastern markets or are trying to capture local consumer-led growth in countries such as Nigeria. Diversification benefits exist; for example, Nigeria's equity market, dominated by the banking sector with the backdrop of an oil economy, has little correlation with Croatia or Sri Lanka.

Economic and regulatory reforms are taking hold as the "frontier" countries have been beneficiaries of international organizations such as the World Federation of Exchanges, regional stock exchange associations, the International Organization of Securities Commissions (IOSCO), the Committee of European Securities Regulators (CESR), the Information Systems Security Association (ISSA) and the Bank for International Settlements. These organizations have ushered in the standardization of existing equity markets and the rapid development of frontier and emerging market stock exchanges. Working with financial and academic support from agencies like The World Bank, the International Monetary Fund (IMF), Organisation for Economic Co-operation and Development (OECD) and the U.S. Agency for International Development, they have helped frontier countries and newly opened stock markets to develop the necessary regulatory, legal, clearing and settlement systems needed to attract foreign portfolio capital. Most recently, the diffusion and availability of trading technology platforms and electronic communication have further enabled market infrastructure development. Because of the small size of many of these markets, liquidity remains an issue.

Defining "Frontier Markets"

The term "frontier markets" conjures ideas of an exotic set of markets somewhere beyond the "emerging" realm of most portfolios. There is general agreement that frontier markets entail both higher levels of risk and higher returns. They also have low correlation to emerging and developed markets. However, there is no widely accepted definition of what really constitutes a frontier market, particularly in the world of indexing and financial product creation. Index providers have labeled varying arrays and constellations of countries as "frontier." Similarly, financial products have come to market targeting groupings of "frontier" countries, usually offering exposure to what seems to be "frontier" through cross- or non-domiciled holdings.

Though most index providers agree on what developed markets are, disparity grows along the spectrum, moving away from the developed category, through the emerging category, toward the frontier tail. This stems from the need to include hot or rapidly growing, highly capitalized markets for performance bets and/or because inflexible country categorization systems lack a disciplined methodology. In many ways, the "frontier markets" of today are similar to the emerging markets of 10 years ago.

A country classification definitional system should be rules-based and complete. It should be robust enough to span the continuum from a developed category, to emerging to frontier and then beyond. Furthermore, it should allow for the promotion and demotion into and out of these categories. Finally, there should be an engagement process whereby the needs of international investors are communicated to the exchanges and regulatory authorities of the countries in the form of rules or criteria. FTSE uses a comprehensive, rules-based approach to country classification, alongside an ongoing marketwide engagement process, making it well-positioned to define what constitutes a "frontier" market.

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