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LONDON, Jan 17 (Reuters) - Tiny stock markets in countries such as Vietnam and Bulgaria are leaving their bigger emerging and developed peers behind, racing to multi-year or record peaks and hinting at another year of heady gains for frontier markets.
MSCI's frontier index is up almost 3 percent already in 2014, contrasting with losses on the bigger emerging index which are feeling the chill from the U.S. stimulus wind-down.
It also outstrips developed markets, which are flat so far in 2014, with investors seemingly reluctant to take last year's record-breaking rally any further for now.
Twenty of the 26 markets in the frontier index that groups non-mainstream bourses are in positive territory. That makes the index the top performer so far in this admittedly short year-to date, after gold. Some markets - in Vietnam, Lebanon, Pakistan and Bulgaria - have already gained 5-11 percent.
A series of country-specific factors such as privatisations, the repricing of political risk premium and local buying are supporting these markets and insulating them from tapering and an eventual end of money printing in the West.
"Frontier markets have positive local factor stories coming out. They are immune to tapering. They have a lot of country-specific, idiosyncratic factors," said Salman Ahmed, global strategist at Lombard Odier Investment Managers.
Ahmed cited the example of Pakistan, where a peaceful general election in May allowed Prime Minister Nawaz Sharif to form a stable government and implement reforms. "If people start to price in political risk and nothing happens, that political risk needs to be adjusted down," he said.
Karachi stocks hit record highs on Friday and the country's 2017 government bond also scored to all-time peaks for a yield of 7.2 percent.
Frontier markets such as Pakistan tend to have a smaller foreign investor component than in bigger economies such as Turkey or Russia where more than 60 percent of what's available can be in foreign hands.
That makes all the difference at a time when the tide of cheap money gushing from the Federal Reserve is starting to turn, leaving international investors with less free cash to invest in emerging markets.
Some of these foreign investors are more likely to be attracted to the higher-yielding assets that are less correlated with global events. Hence, the recent success of bonds from lesser-known first time issuers from Africa or Central America.
Frontier bonds had total returns of 5 percent last year on one index, compared with losses for most emerging debt. Pakistan, which is gearing up to issue its first dollar bond in 7 years, is one of the top performers there.
"In a world where you're struggling to get 3-4 percent in key developed markets and big (emerging markets) have issues, you can get an extra premium of 400-500 basis points without the ... the tapering drama," Ahmed said.
In Asia, where many countries are hostage to China's economic outlook, Vietnam is defying the general negative trend with benchmark stocks rising in 11 consecutive sessions to the highest level since May 2010.
The market is attracting foreign investors who expect the government will raise foreign ownership limits to 60 percent from 49 percent in listed shares within the next few weeks.
Privatisations are also allowing many foreign investors to grab shares at an attractive discount in blue chip companies which are expected to report solid earnings.
Vietnam will also allow foreign investors to buy bigger stakes in its banks from late February, as part of economic reform programmes by the communist government.
"Vietnam has a unique combination of factors," Juerg Vontobel, Zurich-based founder of London-listed investment firm VietNam Holding.
"Markets are primarily driven by domestic investors. (But) foreign investments have been coming in and Vietnam is a huge benefiary of multinationals' investment."
It may depend on how money is invested, however. Vontobel said two Vietnam exchange-traded funds - which are like stocks but based on holdings of a particular bourse - underperformed the country's VN index by around 10 percent last year.
"ETFs cannot replicate the index and they have to buy when they get new money and sell when they lose money. They have less flexibility," Vontobel said.