Closer Look At Frontier Market ETFs

by on August 12, 2010 | ETFs Mentioned:

As exchange-traded funds have grown in popularity, ETF issuers have gradually ventured into more exotic and unconventional markets in order to differentiate new products from those already on the market. Many firms have set out to offer greater levels of exposure to hard-to-reach developing economies; there are now a number of emerging markets ETFs that go beyond the BRIC, such as those focusing on Mexico or Indonesia. There are also a number of ETFs offering exposure to the world’s least developed economies, those that fall short of even “emerging” status. These markets–known as frontier markets–often come with considerable risk, but can offer attractive return potential as well.

According to MSCI, 26 countries are currently classified under “frontier” status. These economies come from all corners of the globe, including several countries from Latin America, central Europe, Africa, the Middle East, and Asia. Some of the better known frontier markets include Argentina, Ukraine, Kenya, Jordan, and Pakistan. Only one of the frontier markets, Vietnam, is the subject of a company-specific ETF; the Market Vectors Vietnam ETF (VNM) tracks the performance of the Market Vectors Vietnam Index. Market classified as frontier fall into that category for a variety of reasons; generally, the individual country’s regulatory environment, market liquidity, and transparency are keys to determining the current classification.

The Final Frontier

These countries represent an intriguing opportunity for investors in general.“They’re highly volatile, so you need a very long time horizon,” said Darrell S. Zechman, a Chicago-based consultant with Towers Watson Investment Services. “They’re relatively diverse, populous and growing fast, they’re not fully established, but they do merit consideration. People were saying the same kinds of things about emerging markets 15 years ago.” While frontier markets likely shouldn’t make up a core holding of any portfolio, they could potentially serve as a tool to enhance overall returns and potentially even add some diversification benefits [also see Warning: Five Country ETFs Heavily Focused On Financials].

According to Assetcorrelation.com, frontier market ETFs exhibit a low level of correlation with SPY; the three funds profiled below ranged from just 0.50 to 0.73 over the past year. By comparison, the largest China ETF (FXI) had a correlation of 0.79 over the past year. The iShares MSCI Canada Index Fund (EWC) exhibited a correlation of 0.89 over the last year, while the most popular emerging markets ETF, the MSCI Emerging Markets Index Fund (EEM), came in at 0.91 [see which ETFs have holdings in any country by using our free Country Lookup Tool].

Ways To Play

Currently, there are three ways to invest in frontier markets with ETFs; the Market Vectors Africa Index ETF (AFK), the PowerShares MENA Frontier Countries Portfolio (PMNA), and the Claymore/BNY Mellon Frontier Markets ETF (FRN). Below we highlight some of the key differences between the funds investors have to choose from in order to establish exposure to these risky but potentially very lucrative markets [also see The Next "Frontier" In ETF Investing].

  • PMNA: This fund focuses in on countries located in the North Africa and Middle East regions, many of which fall into the frontier basket. PMNA tracks the Nasdaq OMX Middle East North Africa Index, and is heavily focused on financials. This sector makes up close to 60% of PMNA’s total assets and accounts for both of the fund’s top two holdings: Arab Bank (10.2%) and Emaar Properties (8.1%). In terms of individual country exposure, the fund allocates roughly 20% to each of the UAE, Egypt, and Kuwait. Large allocations are also given to Morocco (16%) and Jordan (10%) as well, and it even some exposure to Lebanon and Oman. PMNA charges an expense ratio of 0.70%, a pretty competitive fee considering the exposure offered [see more of PMNA's holdings here].
  • FRN: This fund tracks the Bank of New York Mellon Frontier DR Index in order to offer investors exposure to these high risk markets. The index provider defines “Frontier Market” countries based upon an evaluation of gross domestic product growth, per capita income growth, experienced and expected inflation rates, privatization of infrastructure and social inequalities. Currently, the fund has almost 40% of its assets in financials firms with roughly13% going towards utilities, energy, industrial materials, and telecommunication firms. FRN’s largest country weightings are to Chile (28%), Egypt (15%), and Colombia (12%). The fund also offers exposure to some interesting and hard-to-reach markets as well; it has a 6.4% of assets allocated to Lebanon and a 5.1% allocation to Kazakhstan. FRN is one of the cheaper funds targeting frontier markets, charging investors just 0.65% [see more fundamentals of FRN here].
  • AFK: As its name suggests, this fund focuses on securities which are headquartered or generate more than 50% of their revenues in Africa by following the Dow Jones Africa Titans 50 Index. The fund holds 50 securities in total with a heavy weighting towards financials (43%), industrials materials (24%), and telecommunications (17%). In terms of country allocations, the fund is heaviest in South Africa (26%), Egypt (20%), Nigeria (18%), and Morocco (12%). While AFK isn’t a pure play on frontier markets–South Africa, for example, falls into the “emerging” bucket. This fund from Van Eck charges an expense ratio of 83 basis points [also see Time For An Africa ETF?].

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Disclosure: No positions at time of writing.