August 23, 2014

Frontier Markets ETFs: Should You Consider Adding Them to Your Portfolio?

You're a brave investor. You fear no volatility and you'll go to the ends of the earth in your quest for double-digit returns. You're willing to take on a high degree of risk for outsize gains, and in the battle of frontier markets vs. emerging markets, only pansies invest in emerging markets.

With inflows of $2.2 billion into frontier markets, should you jump on the bandwagon? In concept, the idea of investing in pre-emerging markets sounds like a great way to get in on the ground floor of some of the world's next booming economies. Even better, the Wall Street Journal quoted research claiming frontier markets were actually far less volatile than both emerging markets and developed markets? What? We can have our cake and eat it too?!

Okay, so let's say frontier markets really are the best of both worlds. What's the best best way for a guy like me to invest in them? And better yet, what exactly are frontier markets? To answer the second question first, there are no less than five frontier markets indexes in existence. The number of constituents in each ranges in the neighborhood from around 25 countries up to 40 or so. Whereas emerging markets indexes are often made up of larger, more established economies like China, Brazil, India and Taiwan, frontier markets tend to be those countries that do have investable companies but are much smaller and more difficult to access. So we're talking markets in the Middle East, Eastern Europe, Asia, and South America.

Individually, it's possible for U.S. investors to access individual countries within the frontier markets category (like the iShares MSCI Qatar Capped ETF - QAT, or the Global X MSCI Argentina ETF - ARGT). However, many of these funds have relatively low trading volume (think 5,000-20,000 shares/day) and assets (under $50 million). To give you an idea how small this is, top China and Brazil ETFs (FXI and EWZ) both have around $5 billion in assets and trade roughly 15 million shares daily. Frontier markets can be really small.
Looking out the window at frontier markets investing opportunities
That being the case, an interested investor would probably be better served looking at broader funds. There are far fewer choices than you'll find in either emerging or developed markets. Currently, the the iShares MSCI Frontier 100 ETF (FM) is by far the largest covering this segment, with about $800 million in assets. Both Global X and Guggeheim run frontier markets ETFs that are far smaller.

FM is about 23% invested in Kuwait, over 13% in Nigeria, just under 11% in Qatar, 10% in the United Arab Emirates, and Argentina is the largest South American country in the index with about 7% of assets. So it's concentrated with those five countries alone making up more than 60% of the index. From an individual stock standpoint, the top 10 holdings make up a third of this ETF.

Regardless of its concentration in few companies, I'd much rather consider investing in FM than attempting to cherry-pick individual frontier markets countries. Much like micro caps in the U.S., it's just too much of an uphill battle trying to get into stocks that are barely investable.

So with that behind us, let's take a look at the claim that frontier markets are less volatile investments than emerging markets. Since FM is less than two years old, I decided to take a look at MSCI historical data for the Frontier 100 Index (that FM is based on) so we can look a little further back. I compared its total returns against the MSCI Emerging Markets Index (which EEM is based on).

Indeed, it's remarkable how relatively smooth the frontier markets look in the chart below in comparison to their big brothers (much bigger - the market cap of each respectively is $109 billion to $4 trillion). It's been a pretty smooth ride since mid-2009 or so. So I really can't argue the lower volatility point.

Historical returns of iShares FM Frontier Markets 100 ETF vs EEM Emerging Markets ETF

But what bothers me is what happened during the crash. In theory, people like to gravitate toward low volatility securities in the hope that they may be safer investments during a sharp downturn. Big, safe blue chip companies generally fared better than more volatile smaller companies.

So if frontier markets are less volatile (than developed markets even!) and provide the potential for more upside, we should all have a big portion of our portfolios invested in these little dynamos, right? Well, lower volatility isn't always the same thing as less risk.

In fact look at the period between late mid 2008 and early 2009. Before the bottom fell out from underneath the market, frontier markets had marched over 5% higher while emerging markets fluctuated between losing breaking even and dropping around 10%. But when things were at their worst, each investment behaved exactly as you would expect (looking at end-of-month adjusted close data):
  • An investment in the S&P 500 (SPY) would have dropped around 48% from the end of November, 2007 to early February of 2009 (the stretch of time for which we have corresponding frontier markets data).
  • Emerging markets bounced around from November, 2007 through May, 2008 before they ultimately fell over 58%.
  • Frontier markets held on into spring of 2008 before they eventually dropped nearly 67% by February 2009.
During the recent bull market, the Frontier 100 has looked like a relatively stable investment. Perhaps there's a good justification for a small portion of a portfolio to be in frontier markets, but I take issue with the suggestion that they may provide any strong degree of risk reduction. Global markets are becoming more and more correlated, and frontier markets are clearly prone to massive sell-offs, losing two-thirds of their value during the crisis.

But that's not the only problem. The iShares MSCI Frontier 100 ETF sports and expense ratio of 0.79%. Emerging markets ETFs from Schwab and Vanguard (SCHE and VWO) can be had with expense ratios of just 0.14% and 0.15%.

From the end of 2007, emerging markets have just about broken even while frontier markets are still negative. In over six years, they haven't fully recovered. Add to that an expense ratio over five times that of some emerging markets ETFs and it's hard for me to see a compelling reason to put money into this asset class.

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