--Frontier stocks touted for their low correlations to U.S., European and emerging-markets equities

--Such stocks also are considered risky and volatile

--Many advisers urge clients to avoid them

 
    By Matthias Rieker

When a high-net-worth client approached Michael Fein three weeks ago with the idea of investing in frontier markets, the financial adviser reacted with a mix of interest and caution for one of 2013's hottest investments.

The client, a physician in his 70s, had cited the nearly 26% return of the iShares MSCI Frontier 100 (FM) exchange-traded fund last year and wondered whether exposure to countries like Qatar and Nigeria would benefit his investment portfolio.

"I said you should buy it in your personal account, I am not following it for you," Mr. Fein, president of CIC Wealth Management in Baltimore, recalls telling the client.

Mr. Fein has a small portion of his own money invested in frontier stocks, which are touted for their low correlations to U.S., European and emerging-markets equities.

But frontier stocks also are widely considered risky and volatile, making them unsuitable for his client's retirement portfolio. "I would never take the fiduciary responsibility of putting that into my client's portfolio," Mr. Fein says.

This middle-ground, invest-at-your-own-risk advice reflects the hesitation of many advisers when their clients express interest in mutual funds and ETFs focused on frontier markets.

In most cases, independent advisers and even some large advisory firms recommend investors stay away from frontier markets for their managed accounts. "We believe that most clients can build well-diversified portfolios that meet their financial goals without an allocation to frontier markets," a spokeswoman for Edward Jones says.

Frontier markets are expected to develop into emerging markets over time. Argentina is among them, as well as Romania, Kuwait, Botswana and Vietnam. Those countries are considered risky places to make bets because their governments are often unstable and in some cases corrupt, while economic growth is volatile.

Concerns about the suitability of investing in frontier markets have captured the attention of securities regulators. The Financial Industry Regulatory Authority three weeks ago added frontier markets to its examination-priority list.

"Heightened risks associated with investing in foreign or emerging markets generally are magnified in frontier markets," said Finra, noting that frontier markets offer few investment opportunities, low liquidity and poor investor protections.

For now, the economic expansion in frontier markets is expected to continue into 2014. "The long-term catch-up...for frontier markets remains intact," Citigroup Global Markets Inc. said in a recent research report. This economic growth is being fueled by growing populations, rising productivity and increasing foreign investments, Citi said.

So far, overall investment into frontier funds has remained low. Last year, it was less than half of a percent of total mutual-fund inflows, according to Pershing LLC, a unit of Bank of New York Mellon Corp. (BK) that provides custodial and other services to investment advisers.

Aside from institutional investors such as pension funds, investors in frontier markets were mostly high-net worth individuals attracted to areas less tied to developed and other emerging markets, says Sandy Bolton, Pershing's director of investment solutions.

James Cahn, the chief investment officer of the Wealth Enhancement Group in Plymouth, Minn., says frontier funds have a place in diversified investment portfolios. "You've got growth, you've got great valuations," he says.

If a client wants to capture a bit of this market to help diversify a portfolio, exposure should never exceed 2% or 3%, several advisers say.

But Mr. Cahn warns: "If there is a selloff, it's sharp."

That is what worries regulators, and Finra's "red flag" means advisers "better have a really good justification as to why that product was suitable for that particular client," Ms. Bolton says.

"It's putting a greater burden on broker-dealers to have a really robust due-diligence department within their firm to be able to go through all these different funds and come out and say whether they want their adviser to be even selling them," she adds.

In addition, some of the mutual funds focused on frontier markets have already shut their doors to new money because of limited investment opportunities. That could overinflate the values of rival ETFs, an outcome that would be difficult for the average retail investor to know, Ms. Bolton says.

Some firms are already cautious. "We are planning to enhance investor education about frontier funds to make certain that clients are well aware of the risks as well as the opportunities associated with them," a spokesman for Wells Fargo & Co.'s (WFC) brokerage unit Wells Fargo Advisors says.

Other firms, however, remain committed. "We do make frontier funds available," a spokeswoman for Charles Schwab Corp. (SCHW) says. "There are no changes planned at this time."

Write to Matthias Rieker at matthias.rieker@dowjones.com

Subscribe to WSJ: http://online.wsj.com?mod=djnwires