Why Frontier Market ETFs Are Not As Risky As You Might Think

by on September 16, 2010 | ETFs Mentioned:

As investor confidence in developed markets has waned in recent months many have taken their dollars abroad in an attempt to buy into high growth emerging markets overseas. While a good chunk of this cash has piled into the BRIC countries and other large emerging markets such as Indonesia, some have taken a different route and have put the frontier market ETFs under the microscope. However, investors who think that these funds are at the top of the risk spectrum for international equities may be extremely disappointed if they take more than a cursory glance at the funds’ top country allocations.

By popular definition, frontier markets are known as “pre-emerging markets” and may face any or all of the following risks; political instability, poor liquidity, inadequate regulation, substandard financial reporting and large currency fluctuations. In addition, many markets are overly dependent on volatile commodities. While this can create opportunities for investors seeking uncorrelated equity exposure, many of the countries on the list are either among the richest countries in the world, or up-and-coming nations which have seen significant problems in the past but have made great strides in recent years.

Currently, there are two ETFs which target this segment of the world; the Claymore/BNY Mellon Frontier Markets ETF (FRN) and the PowerShares MENA Frontier Countries Portfolio (PMNA). Below we profile these two funds in greater detail and discuss some of their holdings which may come as a surprise to many investors seeking high risk/high reward markets [see Emerging Markets ETF Boom Continues].

FRN- Claymore’s foray into the frontier market space seeks to offer investors diversified exposure to the market sector by having FRN track the Bank of New York Mellon New Frontier DR Index. This index tracks the performance of depositary receipts, in ADR or GDR form, that trade on the London Stock Exchange, New York Stock Exchange, NYSE Amex and Nasdaq Stock Market of companies from countries that are defined as the Frontier Market. 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 [see Closer Look At Frontier Market ETFs].

While this methodology does a good job of tracking more undeveloped countries, including a 5.2% allocation to Lebanon and a 4.4% allocation to Kazakhstan, some could argue it is too concentrated in relatively developed markets in South America. In fact, the fund’s two top holdings are Chile and Colombia, two countries which have made great strides in recent years and may no longer be appropriate for inclusion in this type of index. Chile now rates in the top thirty for ‘most competitive countries in the world‘ beating out developed markets such as Spain and Italy, further making the case for the Chilean economy to move out of this classification.

PMNA- This fund from PowerShares offers exposure to the Middle East and North Africa by tracking the NASDAQ OMX Middle East North Africa Index. The index seeks to provide direct exposure to liquid stocks of companies that have the majority of their assets or services residing in MENA frontier market countries, which include Egypt, Morocco, Oman, Lebanon, Jordan, Kuwait, Bahrain, Qatar and United Arab Emirates. While a number of these countries represent risky markets such as Morocco and Jordan, which combine to make up close to 24% of the fund’s total assets, large allocations go towards the United Arab Emirates and Kuwait which makes up 42% of the fund.

While arguably not the most liquid markets and certainly not democratic nations, both the UAE and Kuwait find themselves as two of the most developed countries in the world according the Human Development Index which ranks them far ahead of countries such as Russia, Brazil, and Indonesia. While not necessarily a problem, one has to wonder how much growth can come in a country that has already seen such a high level of development or one that has a per capita GDP that is higher than the U.S. as is the case of Kuwait which sees an average income of $52,800, more than $6,000 higher than corresponding levels in America [also read Middle East ETFs In Focus As BlackBerry Showdown Looms].

While there is certainly nothing wrong with these funds, investors who buy into these two ETFs thinking that they are accessing some of the riskiest, least developed markets in the world may be very disappointed. This just goes to show you how important it is to take a close look at fund’s holdings and that you cannot rely on simply looking at the fund’s name or ticker as a way to determine the fund’s investment strategy [see all the ETFs that have exposure to your favorite country by using the Country Exposure Tool].

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Disclosure: No positions at time of writing, photo is courtesy of Ryan Lackey.