ETF investing: Is the ‘frontier’ market the new ‘emerging’ market?

The investment case for frontier markets sounds enticing. These countries, such as Vietnam, Nigeria and Pakistan, are at an earlier stage of development relative to emerging-markets countries, and some are entering a period of mid- to high-single-digit growth, thanks to favourable demographics, infrastructure spending and an improving business environment. Another positive trend is that a number of resource-rich countries have been able to channel some revenues from the export of raw materials into infrastructure and social spending.

Although frontier economies are less developed than emerging economies, the MSCI frontier index has been less volatile than the MSCI emerging markets index over the past 15 years. Part of this is attributable to the fact that individual frontier countries have low correlations with each other. Another reason is the relatively low level of foreign ownership of frontier-markets stocks. One of the main drivers of volatility in emerging-markets equities during the past few years has been the fact that emerging-markets equities have been considered a “risk on” asset class in the recent “risk-on, risk-off” trading environment. Given the relatively low foreign investor penetration in frontier-markets stocks and bonds, this asset class has not been as susceptible to this hot money-driven volatility.

The MSCI frontier market index covers about 85% of the free-float-adjusted market capitalization of 25 frontier stock markets. The index has a total of 142 constituents, whose combined free-float-adjusted market capitalization is around US$130 billion, equivalent in size to the market capitalization of individual companies such as PepsiCo (NYSE:PEP) or Merck (NYSE:MRK). By way of comparison, the free-float-adjusted market capitalization of the MSCI Emerging Markets Index is US$3.9 trillion.

With such limited capacity, strong inflows into frontier-markets stocks will likely drive markets higher. However, any sudden pullback by foreign investors could result in brutal declines. Emerging Southeast Asian markets, which boast far more liquidity than frontier markets, were recently victims of this phenomenon. For example, iShares MSCI Philippines (EPHE) and iShares MSCI Thailand (THD) exchange-trade funds (ETFs) enjoyed an 80% and 60% climb, respectively, from January 2012 through mid-May this year, due in part to surging inflows into both local equities and bonds, which drove up both equity prices and currencies.

The rally hit a wall when the Federal Reserve Chairman Ben Bernanke first hinted at an eventual tapering of the Fed’s asset purchases, and in the following three months, these funds each fell 30%. If investors continue to pile into frontier markets, they too will become part of the risk-on, risk-off trade, and will likely grow more correlated with developed markets.

Most investors are familiar with the main risks associated with frontier markets, which include political instability, social unrest, widespread corruption and a fickle regulatory environment. For example, during the Egyptian Revolution of 2011, the local stock market shut down for 40 consecutive days, and Market Vectors Egypt (EGPT), an ETF that primarily invests in Egyptian securities, fell 50% that year. Argentina, another former high flyer, is now an economic basket case. MSCI downgraded Argentina from the emerging markets index to the frontier markets index in 2009 as a result of restrictions on the flow of capital into and out of the country. Currently, MSCI is considering excluding Argentina from the frontier market index after the nationalization of energy company YPF in 2012, a company that was 51% owned by Spanish oil firm Repsol SA.

After acknowledging the many risks to frontier markets, investors should also carefully weigh the pros and cons of the different funds offering exposure to this very niche asset class.

Currently there are no Canadian ETFs dedicated to frontier markets, but plenty of options exist south of the border. Passively managed iShares MSCI Frontier 100 (FM) is by far the cheapest option for geographically diversified frontier-markets exposure. This ETF has an annual expense ratio of 0.79%. Since inception in September 2012, it has trailed its index by 40 basis points, which is less than its annual expense ratio, indicating the fund is doing a good job tracking its index.

However, a bigger challenge looms for the managers of this fund, in the form of a large index change, which was announced by MSCI last June. On Nov. 27 Morocco was downgraded from the MSCI emerging markets index (where it accounted for 0.01% of the index) to the frontier markets index (where it now accounts for about 4%), and in May 2014, Qatar and the United Arab Emirates will be upgraded from the frontier markets index (where together they account for 30%) to the emerging markets index (where together they will account for around 1%).

Index-tracking funds that invest in relatively illiquid securities face two key challenges: front running and market impact costs. These issues affect both the fund and the index, making it difficult to measure their effect. Morocco’s Casablanca Stock Exchange expects the market downgrade will result in additional fund flows; while emerging-markets fund managers may have ignored Morocco because it represented a small sliver of their benchmark, frontier-markets fund managers will likely consider Moroccan stocks given their more significant weighting in the frontier benchmark.

Moroccan stocks have enjoyed somewhat of a rally during the past few months, which the iShares MSCI Frontier fund had missed by the time it added Moroccan securities. Following this and the May index changes, FM’s portfolio will be more concentrated, as Kuwaiti stocks (which will account for about 30% of the fund’s portfolio) and Nigerian stocks (20%) will account for roughly half of its assets.

As Morocco may benefit from a downgrade to frontier status, Qatar and UAE may benefit from an upgrade to emerging-markets status. Often, a country is upgraded in recognition of significant economic reforms, which are often a precursor to an improved growth outlook. Reclassification also raises the profile of a country’s stock market within the foreign investment community and could drive significant capital inflows.

Egypt was a glowing success story for a few years after it was added to the MSCI emerging markets index in June 2001. Thanks to tariff cuts, economic liberalization and privatization, Egypt enjoyed strong increases in foreign direct investment and portfolio inflows, and from 2003 to 2007, the MSCI Egypt index returned an average of 84% a year. A strict frontier-markets index fund such as FM would have missed out on this type of market performance. (That said, the Egypt story has definitely taken a more negative turn in more recent years, and MSCI is currently looking to remove Egypt from the Emerging Markets Index as it has become more difficult for foreign investors to repatriate their capital. This is yet another example of the many risks of this asset class.)

Because countries at the border between frontier and emerging markets may benefit from increasing investor interest, as well as improving fundamentals, a better option may be a fund like EGShares Beyond BRICs Frontier (BBRC). This fund, by investing in smaller emerging markets (75%) and frontier markets (25%), will most likely include these borderline countries and see less turnover as it won’t have as many country upgrades and downgrades. This will also help reduce transaction and market-impact costs, relative to an index fund like iShares MSCI Frontier. However, while BBRC is more geographically diverse, a number of smaller countries are represented by only one security. This fund is also still quite small, very thinly traded, and only recently added frontier-markets stocks when it changed its benchmark index in October 2013. Given its small size, there is a risk that this fund could ultimately close. And in light of its sparse liquidity it is important to use limit orders to ensure good execution for smaller trades.

An actively managed fund would probably be the best option for frontier-markets exposure. Frontier stocks, like micro-cap stocks, are relatively illiquid and are not well covered by investment analysts. Specialist active managers with focused analyst staff may be better positioned to exploit these inefficiencies.

At this time there is only one mutual fund in Canada that provides dedicated exposure to frontier markets: Templeton Frontier Markets Corporate Class Fund. While that fund was only launched in July 2011, it is a clone of a U.S.-sold fund that has a five-year track record and a 4-star Morningstar rating. It is managed by a team led by Mark Mobius, who has been at the helm of Templeton Emerging Markets Fund for more than 20 years. As more investors start paying attention to this corner of the investing world, more entrants are likely to follow.

Patricia Oey is a senior analyst covering passive international equity funds for Morningstar Inc.