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Funds Look to New Frontiers with Caution

Emerging markets have become the new hot spot for mutual fund companies and investors looking to diversify their portfolios internationally, but analysts say even countries like China may be too correlated to the U.S. economy to escape a global recession-prompting some to look further, to new frontiers.

"The strongest economy in the world is the United States, but if there are problems in the U.S., it affects the world," said Dunny Moonesawmy, head of research for western Europe and the Middle East for Lipper.

"Chinese market influence in the Asian region is too strong," he said. "A recession in the U.S. will affect China. If China has growth issues, it will affect all the countries in the region. The whole global market future is gloomy."

Fund companies looking for long-term investment diversification should consider frontier markets in the Persian Gulf, Eastern Europe, Africa, South America and Southeast Asia, Moonesawmy said. Key frontier countries include Saudi Arabia, Kuwait, the United Arab Emirates, Vietnam, Kenya, Nigeria, Ukraine, Jordan and Columbia.

Advantages to investing in frontier markets include a greater potential for growth and a lack of correlation to the U.S. economy, Moonesawmy said. However, there are disadvantages, including greater risk, smaller market size and poor liquidity. Portfolio construction and trading are also more challenging; there are only about 540 stocks traded across 22 frontier markets, according to a report by Acadian Asset Management.

Frontier markets tend to be thinly traded equity markets with weak regulatory frameworks, low levels of foreign ownership and low levels of transparency, concurred a recent report by Merrill Lynch. They represent about a billion people, have a nominal gross domestic product of $2.4 trillion and a market cap of $1.7 trillion.

Reasonable Growth

But they do offer opportunities. "While frontier markets are generally small in size and lacking in economic sophistication, most of them have a reasonable growth foundation and knowledge base," according to Acadian. "They may never rival Korea, Taiwan, China, India, Brazil and Russia in their global influence and ability to attract investment. However, they are arguably comparable to some smaller emerging markets, and could offer great development potential and investment opportunities."

Many frontier countries have solid infrastructures in education, government and the economy, and many are developing viable capital markets, Acadian said.

The average annual market return for frontier countries has been 15% from January 1996 through March 2007, according to Acadian, and 2006 was a very good year for frontier markets, with an index return of more than 51%.

A few fund companies are already offering frontier funds, such as T. Rowe Price's Africa & Middle East Fund.

Hello, Dubai

Moonesawmy recently came back from his fourth trip to Dubai in the past year and commented on how impressed he is by the country's booming economy.

"It's extraordinary," he said. "More than 300 towers are being built in Dubai right now. They are building new cities. They're building a new country."

If experts are correct in predicting that oil reserves in the Middle East could be exhausted in the next 20 to 40 years, the region will need to prepare itself for the future, Moonesawmy said.

Real estate, construction, airlines and tourism are all booming in Dubai, as the country looks for ways to diversify its economy. This diversification is creating a new type of wealth in the region and a whole new middle class, as opposed to a welfare state where only a few families profit from oil revenues.

"In the next five years, the country will change dramatically," Moonesawmy said. "It has already changed dramatically in the last five years."

Last week, the Abu Dhabi Investment Authority, the nation's sovereign investment fund, said it will invest $7.5 billion in Citigroup, helping the U.S.'s largest bank offset mortgage losses. Dubai-owned DIFC Investments just announced it was interested in investing in U.S. oil and gas, telecommunications and real estate companies. Last month, Dubai Aerospace Enterprise purchased nearly $30 billion in airplanes from Boeing and Airbus. Moonesawmy said Dubai's airplane orders are evidence of the country's ambition.

"It shows they want to develop a large network," he said. "They want to dominate the market and lead the airline industry."

But the country's ambitious plans may see resistance from the U.S. and other Western countries if they try to grow too big too quickly.

Dubai-based DP World-a major global shipping authority and the world's fourth-largest port operator-acquired several major U.S. ports last year, but was forced to sell the ports after the U.S. House Appropriations Committee voted to block the deal for fear of turning control over to a Middle Eastern company.

Moonesawmy cautioned that investing in frontier markets can help diversify a portfolio, but investors should not be overexposed to frontier economies.

Long Horizon

"When investing in frontier markets, you should look at a 10-year time horizon," agreed Annie Sorich, a mutual fund analyst for Morningstar. "From a mutual fund perspective, you don't hear managers talk about frontier markets."

Sorich said it can be exciting to invest in frontier markets in far-flung places in the world, but it's not a necessity for most investors.

"The more risk you take, the higher the return potential," she said. Many frontier areas are contingent on high oil prices, and their economies will probably be profitable as long as oil prices keep rising, she said, but an economy based on commodities can be extremely volatile. "Everything on the Nairobi stock exchange is on hold until the next election," Sorich said. "It could go either way, depending on what happens."

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