The Next “Frontier” in ETF Investing

by on June 22, 2009 | Updated May 14, 2013 | ETFs Mentioned:

Many investors who had the resolve to keep their equity holdings in place as global markets plunged to new lows in the first few months of 2009 were the beneficiaries of a familiar gift from an old friend. Emerging markets, which have regularly enhanced investor returns in recent years (well, prior to 2008 at least) have led the way in the recent bull run, recovering a significant portion of the disproportionate losses they incurred during the global recession. But as the ETF industry continues to expand, investors may begin to look beyond emerging markets to a new group of countries for both international diversification and enhanced portfolio returns.

Over the last several years, multiple ETF issuers have introduced frontier markets ETFs, funds tracking indexes based on the stock markets of those countries one stage below “emerging” status. These markets, which can experience explosive growth during bull markets but suffer severe losses during downturns, may become increasingly popular if risk aversion continues to dissipate and investors’ appetite for risky equities returns.

Let’s Get Technical

While many investors think of it as a general term referring to rapidly-developing countries, “emerging” actually refers to a technical classification made by various index providers. MSCI Barra, one such provider that maintains dozens of domestic and international equity indexes, analyzes 75 markets around the world on four market accessibility criteria, including: (1) openness to foreign ownership, (2) ease of capital inflows/outflows, (3) efficiency of the operational framework, and (4) stability of the institutional framework.

Based on their performance in these areas, each market is slotted into one of three categories: developed, emerging, or frontier.

MSCI’s “frontier” designation currently includes 25 countries [PDF] in all parts of the world, including the Americas (Argentina), Eastern Europe (Kazakhstan), Africa (Kenya), the Middle East (Kuwait), and Asia (Pakistan). There are several other similar but separate frontier classifications, including the S&P Frontier Composite, which includes 21 country indexes.

Risk and Reward

Compared to developed and emerging nations, frontier markets have significant market accessibility issues, resulting in significant investor risk. Geopolitical risks and outright corruption are commonplace, as many of these nations have had limited success implementing and enforcing sophisticated securities regulation. But with this significant risk comes potential for significant reward.

While the populations of frontier markets tend to be poor, their incomes are increasing, thanks in large part to reduced global trade barriers and increases in commodity prices. And in countries where governments have instituted sound monetary and fiscal policies, the potential for rapid expansion and inclusion among the emerging markets of the world is very real. “Frontier markets are where emerging markets were, in some cases, 10 to 20 years ago,” says Antoine Van Agtmael, the chief investment officer of Emerging Markets Investors who is credited with inventing the term “emerging markets” in the 1980s.

According to Vito Racanelli at Barron’s, frontier markets often offer potential for greater payouts due to the presence of numerous inefficiencies in asset pricing and flow of information. But they can also be extremely volatile. Many frontier markets are heavily dependent on a single natural resource, creating the potential for market crashes in the event of falling prices. Moreover, rocky political situations in many frontier nations mean that government coups or asset seizures, which are unlikely scenarios in developed and emerging markets, are a distinct possibility.

ETF Options

With the growth of the ETF industry, investors now have multiple options allowing them to gain cost-efficient, well-diversified exposure to frontier markets. A few of the frontier markets ETFs on the market include:

  • Claymore/BNY Mellon Frontier Markets ETF (FRN): Launched in June 2008, FRN has assets of approximately $15 million and has its heaviest concentrations in Chile (34%), Poland (20%), and Egypt (15%). Holding investments in regions throughout the world, FRN is perhaps the best diversified frontier market ETF available.

FRN

  • PowerShares MENA Frontier Countries Portfolio (PMNA): This ETF tracks the NASDAQ OMX Middle East North Africa Index, which includes liquid stocks of companies operating in MENA frontier market countries, including Egypt, Morocco, Oman, Lebanon, Jordan, Kuwait, Bahrain, Qatar, and the UAE. Although focused on traditional oil-exporting countries, PMNA maintains relatively little exposure to the oil industry, with its heaviest concentrations in the financial and telecommunications sectors. Launched in July 2008, PMNA also has assets of approximately $15 million.

PMNA

  • Other ETFs offering more targeted exposure to frontier markets include GULF (Gulf States), MES (Middle East), and AFK (Africa).

As the funds above illustrate, frontier markets ETFs are far from homogeneous at this point, with different funds offering exposure to widely different markets. If and when appetite for risk returns, I wouldn’t be surprised to see more issuers jumping into this corner of the ETF market. If frontier markets continue to outpace their more developed peers, they’re likely to be the recipients of significant cash inflows in the coming months.