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Stocks from Nigeria and Sri Lanka may not be on your radar, but they're on fund managers'

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NEW YORK, N.Y. - Finding stocks that zig when others zag is a key goal for investors, and mutual fund managers say they're finding candidates in places that may be unfamiliar. They're delving deeper into less-developed economies, buying stock in Nigerian breweries, banks in Kazakhstan and cement companies in Colombia.

Trading in such markets is more difficult and the threat of big losses is higher. But proponents of so-called frontier markets say they are where Brazil, China, India and other big emerging markets were 20 years ago. And while investing in stocks from those countries may have seemed wild then, today they're just a de rigueur part of an emerging-markets portfolio.

Frontier-market investing covers a wide range of economies from huge countries like Pakistan, one of the world's 10 largest by population, to Mauritius, which has fewer people than Idaho. What they have in common are economies or stock markets that are less developed than traditional emerging markets, such as China and Brazil, which are themselves less developed than the U.S., Japan or Germany.

Because of their smaller size and increased risk, conventional wisdom said that frontier-market stocks should behave like emerging-market stocks on steroids: They should have higher highs and lower lows. But over the last year, frontier-market stocks haven't been dragged down by worries dogging large emerging markets.

Over the 12 months ended in April, the MSCI Frontier Markets index returned 27.9 per cent in U.S. dollar terms, including dividends. China, Brazil and other more established emerging markets, meanwhile, lost 1.5 per cent as measured by the MSCI Emerging Markets index.

Part of the allure is that frontier markets aren't yet fully part of the global economy. They don't have big exporters like South Korea's Samsung, whose revenue depends heavily on the global economy's strength. That means the direction of a frontier market's stocks is more heavily reliant upon the strength of its own economy. And expectations for many frontier economies are high.

The focus on the growth of the local economy can lead to big differences in performance. Consider the United Arab Emirates. Through the end of April it surged 40.4 per cent. Kazakhstan, also a member of the frontier index, fell 7.1 per cent.

Such differences are a positive for investors, says Rick Schmidt, portfolio manager at Harding Loevner's Frontier Emerging Markets fund (HLMOX), which has returned 18.8 per cent over the last year.

"The individual country risk is very high: You can have a coup over here and an invasion over there," Schmidt says. "But because none of them affects what happens in other markets, when you own a portfolio of those, you're actually reducing risk."

To be sure, as frontier markets grow, their ties to the global economy will likely strengthen. That means their stock markets would eventually move more in sync with other global markets. But investors now are noticing the strong performance and diversification that frontier markets have recently provided.

Big institutional clients and financial advisers are asking more often whether they need to be in frontier markets, Schmidt says. So, what's the answer?

"If you can handle the risks and hold through this thing for five years, frontier is an asset class that is very exciting," he says.

Frontier markets would likely be a small part of an investor's portfolio. But investors need to be aware of the risks involved.

— COUPS, WARS AND OTHER POLITICAL RISKS.

When the protests of the Arab Spring swept through Tunisia and other countries, markets quickly tumbled. Tunisian stocks lost 19 per cent in the first eight weeks of 2011.

Earlier this year, tensions between Russia and the United States about Ukraine led to falling markets around the world. Surprisingly, Ukraine's stocks have done well: They returned 4.6 per cent through April. That's because of the increased global attention, which has led to billions of dollars in loans for Ukraine, says Nathan Rowader, portfolio manager of the Forward Frontier Strategy fund (FRONX).

"As hard as it is, the annexation caused a real change in fortunes," Rowader says.

— BIG LOSSES ARE POSSIBLE.

Frontier-market stocks are still below their 2008 peak.

That's in part because of their particularly steep declines. In 2008, frontier markets plunged 54.1 per cent, compared with a 37 per cent fall for the Standard & Poor's 500 index. In 2011, frontier markets lost 18.4 per cent, when the S&P 500 returned 2.1 per cent.

One of the risks in frontier markets is that stocks are tougher to trade: It can be difficult to find a buyer when you want to sell.

— PRICES ARE HIGHER FOLLOWING A BIG RUN.

As a group, frontier-market stocks are more expensive than those of other regions. At the end of the first quarter, they were trading at an average 14 times their earnings per share over the last 12 months. That's higher than the average price-earnings ratio of 12 emerging markets.

Fund managers say much of that gain is due to just a few countries and may soon be alleviated. The United Arab Emirates has nearly doubled over the last 12 months, while Qatar is up nearly 50 per cent. The pair together makes up about a third of the MSCI Frontier Markets index.

But both markets are graduating to the MSCI Emerging Markets index after the end of the month. Following that, price-earnings ratios for frontier markets will likely drop.

— COSTS ARE HIGHER.

Trading stocks in frontier markets is more expensive than trading in the U.S., which has translated into higher expense ratios for frontier-market funds.

Harding Loevner's Frontier Emerging Markets fund has a net expense ratio of 2.23 per cent, for example. That means $223 of every $10,000 invested in the fund goes to cover annual costs after waivers made by the managers. Lower expenses are available among frontier funds that track an index.

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