Frontier ETFs: Investing at the Ends of the World

Saturday, September 12, 2009

Frontier markets are the Wild West of international investing. Not yet stable enough to be called emerging, frontier markets deliver tremendous returns to compensate investors for their substantial risk. A handful of ETFs test these choppy waters with sometimes quirky choices of holdings.

The appeal of frontier investing is that the fastest growing countries are all economically delayed. What three countries will grow the fastest in 2010, according to the International Monetary Fund? Qatar, Liberia and Angola. The slowest three are all fully developed European economies.

Boosting appeal further, frontier markets risk fades when they are added in small amounts to a portfolio. This is because frontier markets tend to correlate poorly with developed ones. When used in this context, frontier ETFs can deliver superior returns at sometimes less risk than many other developed economy ETFs.

Africa, most Gulf states, various former Soviet republics in Asia and certain Latin American countries are the traditional frontier areas. But definitions evolve as frontier markets graduate to emerging status, and opinions differ on who deserves what title. One man's emerging market is another's frontier. We define frontier markets as suffering from extreme volatility, thin trading, corruption, sloppy accounting and a tendency to confiscate foreign capital. Other than that, they are a fine place to do business!

Africa is the quintessential home for frontier equities. While Africa lags other continents economically, it weathered 2009 better than many other geographic regions:

Africa is lightly leveraged, so it did not suffer as much from the global contraction of credit. For most companies the only way to operate there is with ready cash. Also, its natural resource economy is relatively diverse so it can absorb shocks to individual commodities. Just about every commodity is extracted there in meaningful amounts, from oil to diamonds to cocoa.

China is an important factor for Africa. Its voracious appetite for raw materials is driving valuations up all over the continent. And China is spending billions on infrastructure which should help all industries bring products to market.

Oil-rich states of the Persian Gulf and Middle East have traditionally done most of their business in privately held firms, but their exchanges are developing fast and many are graduating to emerging status. Increasing wealth, transparency and infrastructure will overcome problems of corruption, inefficiency and market manipulation.

Eastern European and Asian nations form another frontier group. Many are former Soviet satellite states still dominated by Russia. Some have ample natural resources. Many are corrupt and riddled with ex-KGB and mafia strongmen.

Finally, certain smaller Latin American countries with poorly developed exchanges and confiscatory tax policies can be considered. Bolivia, Ecuador and Peru are often mentioned. Unfortunately, most Latin American ETFs are dominated by relatively advanced economies such as Brazil. And individual country ETFs do not cover all the riskier nations.

Claymore/BNY Mellon Frontier Markets ETF (NYSEArca:FRN), is seemingly the only ETF targeting frontier countries globally. Its fees are reasonable at 0.65%, and it provides solid exposure to worthwhile countries such as Egypt, Colombia and Kazakhstan. But we take issue with its 33% exposure to Chile. This is far too big for diversified exposure, and Chile is too developed and stable to be frontier. One could say the same for a 15% exposure to Poland which is quickly integrating into Europe economically.

For those just seeking African exposure, there is Van Eck Market Vectors Africa Index ETF (NYSEArca:AFK), with annual fees of 0.83%. It contains large amounts of South Africa, Nigeria, Morocco and Egypt. Some view South Africa as emerging, but even proponents point out that its economy is tied to other African frontier markets. The iShares MSCI South Africa ETF (NYSEArca:EZA) allows direct exposure to that dynamic but tumultuous country.

The Gulf and Middle East is represented by WisdomTree Middle East Dividend ETF (AMEX:GULF), with annual fees of 0.88%, and Van Eck Market Vectors Gulf States ETF (NYSEArca:MES), with annual fees of 0.98%.

SPDR S&P Emerging Middle East & Africa ETF (NYSEArca:GAF) seems to imply broad coverage in two risky areas but in fact has quite narrow holdings. It contains 62% holdings from South Africa., 24% from Israel (clearly an emerging economy or better), and a smattering of Egyptian and Moroccan stocks. Unfortunately, its focus on emerging markets precluded its venturing into Nigeria and various Gulf States, which would have made it more useful to the frontier investor.

Some quite risky Eastern European countries may be found in SPDR S&P Emerging Europe ETF (NYSEArca:GUR), with annual fees of 0.6%. GUR has large exposure to Russia, whose Wild West atmosphere could easily put it in the frontier camp. Foreign investor rights are trampled on heedlessly, accounting fabrications are common, and theft of company assets is rampant. Some investors put Russia in its own class due to the size of its markets, its geopolitical heft and its ample natural resources.

Many frontier investors round out their pickings with country ETFs. Liquidity in country-specific ETFs is often not a problem. EZA, for instance, is far bigger than any other fund discussed in this report with $400 Million in assets.

Frontier is an exciting but slippery area to categorize, and ETFs offer very different ways to address it.

Co-founder of indexfunds.com, author of two books on investing, and founder of ETFzone.com, Will has been writing on indexing issues for 8 years. He holds an MBA from the University of Texas at Austin.