Frontier markets are a category smaller and less accessible than emerging markets. They usually have higher nominal growth rates, younger populations and lower market penetration, and those features form an attractive growth narrative. Between that narrative and whether investment is actually possible, there sits a gap determined by liquidity. The first problem of liquidity is size. A frontier market's total capitalisation is small, the freely floating portion is smaller, and the genuinely actively traded portion is smaller still. This means an institutional investor wanting to build a meaningful position may need to buy a substantial proportion of the market's active float. That process itself pushes the price up considerably.
The second problem is transaction cost. Bid-ask spreads in frontier markets are usually far wider than in developed markets, and the market impact cost of large trades is higher. The returns an index shows are calculated at mid prices, while actual trading has to cross the spread and bear the impact. This makes realisable returns lower than the index shows, with the gap largest in the least liquid markets. The third problem is asymmetry between entry and exit. Most of the time, frontier market liquidity can support slow buying, and during periods of stress liquidity can dry up quickly, making selling difficult or expensive.
This asymmetry means frontier market risk extends beyond price volatility to the possibility of being unable to exit at a reasonable price when exit is needed. Capital controls and currency conversion are a further layer of reality. Some frontier markets impose restrictions or procedures on foreign repatriation, so even after selling a security, converting and remitting the proceeds may be obstructed. This risk has nothing to do with price and directly affects the recoverability of capital, and it tends to worsen at the same time as liquidity stress. The existence of an index easily creates an illusion of investability.
The return of a frontier market index looks considerable, while the actual trading required to replicate it has a cost and feasibility far below what the index implies. An index is a measuring tool, not something that can be replicated cheaply, and that distinction is especially important in frontier markets. The gap between an index return and an achievable return is present in every market. It simply grows large enough in frontier markets that it can no longer be treated as a rounding error.
For investors, the reasonable position on frontier markets is to understand that their growth narrative may be genuine while the practical conditions of participation are severely limited by liquidity. For the great majority of investors, holding these markets indirectly through broad emerging market instruments is sufficient. The liquidity reality facing direct participation usually exceeds what the growth potential can compensate for. This also explains why frontier market funds tend to be small. The constraint is the ceiling that liquidity places on the capital they can hold, rather than any lack of a growth narrative. Once a fund grows beyond a certain size, its own trading significantly affects the markets it invests in. This limits how large such a vehicle can become before it undermines its own execution.