Are Frontier Markets Ready for Prime Time?

Frontier markets represent 30 percent of the world’s population, crammed into some of its fastest-growing economies Photograph by Frans lanting/Gallery Stock

By all means, countrymen, go ahead and celebrate our Dow Jones industrial average at a recordhowever nominal that milestone may be. But perhaps you’re looking for a place to put your money that doesn’t move in lockstep with the U.S. market—at a time when just about everything, including mortgage bonds, traditional emerging markets, and bank loans, does. That place would be the universe of booming small developing markets, which you can now access, substantially, with the help of some newfangled exchange-traded funds.

It was inevitable that ETF innovation—through which you can practically track the real-time pH of Lake Pontchartrain—would come to frontier markets, the indexing farm system beneath more grown-up emerging markets such as Brazil and India. (And, with its recent demotion, Greece.) Destinations like Bangladesh, Vietnam, and Romania—and the majority of Africa—aren’t nearly liquid and listed-up enough to take on anything like the $52 billion stuffed into the iShares MSCI Emerging Markets ETF, which is channeled to big multinationals in China, Russia, Mexico, and the like.

Even so, the frontier represents 30 percent of the world’s population, crammed into some of its fastest-growing economies. Nourished with enough stability and free-market reforms, and the noblesse largesse of foreign investors, frontier markets are primed to go more mainstream, especially with ETFs like the fledgling iShares MSCI Frontier 100 now casting for talent. Seeded with just $10 million when it launched in September, the offering has since swelled to $54 million in assets. The question now is how well this fund, and rival Guggenheim Frontier, can track the momentum of these scattered tiny markets, all while taking in Western money in an orderly fashion.

Witness the Philippine stock market, which is by far the best-performing in the world since the crash of ’08, according to Bloomberg data. Compare this state of affairs with how that economy was devastated in the Asian economic crisis of 1998, when it was so broke that a pair of its national airline’s planes were seized in Los Angeles to satisfy the demands of the U.S. Export-Import Bank. Today, for all its resurgence, Manila’s entire bourse is worth as much as Microsoft. It’s not even represented in the top 10 of the iShares or Guggenheim fund; the former is dominated by Kuwait and Qatar, the latter by Chile and Colombia, all of which are arguably more developed than frontier.

The MSCI Frontier Markets 100 Index that iShares is aiming to track is a subset of the broader MSCI Frontier Markets Index. The FM 100 screens for liquidity and tradability; Kazakhstan, Kenya, and Serbia are among the handful of economies that make that cut. “It is the only pure-play frontier ETF,” says Bloomberg’s exchange-traded fund guru Eric Balchunas. “I give it a lot of credit for trying to hustle down all the local shares in the MSCI Frontier 100 Index. However, given the exotic exposure, you pay for it in terms of a 0.79 percent expense ratio. And it is a little overweighted in the Middle East. But for the opportunity to own local shares in places that really are the new, new emerging countries and in an ETF basket, it is amazing.”

In the three months leading up to mid-February, Balchunas notes, the fund’s volume was up 150 percent. It has gained 5 percent this year, and has doubled the return of the Standard & Poor’s 500-stock index since the ETF’s launch last September.

Guggenheim Frontier tracks a Bank of New York index that Balchunas says is a hybrid of emerging and frontier positions in American depositary receipts (ADRs), as opposed to harder-to-navigate local shares. It is down 3 percent so far in 2013.

Either way, index creep is all the rage in developing markets. Korea, quite developed, is still in the MSCI Emerging Markets index, while Greece, utterly collapsed, was just redefined as an emerging rather than developed market by Russell Investments, which advises funds with $2.4 trillion in assets. Why should it not be a frontier alongside Argentina, which used to be a hot emerging market before going off the rails (PDF) on a crazy train?

Balchunas’s advice is to stay as focused as possible on the frontier’s chief selling point: its lack of correlation to the U.S. market. He calculates that the Frontier 100 index that iShares is attempting to track correlates less than 40 percent to the movements of the S&P 500, while MSCI’s emerging-market basket correlates at more than twice that fraction.

Meantime, this writer remembers the halcyon days of mid-2007, when he got an in-box solicitation for Greece as the best possible marriage of frontiersmanship with euro zone membership. To which he can only quote Aristotle: “Probable impossibilities are to be preferred to improbable possibilities.”

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