iShares' FM: Frontier Of Uncorrelated Markets

Recent MSCI classification changes have brought frontier markets back into focus again, but these markets have long been on my radar for reasons beyond index reclassifications.

For starters, frontier markets are relatively untapped markets compared with emerging markets, and provide tremendous opportunities for growth. Again, think of many emerging markets in the late ’90s.

But to me, the attraction of frontier markets goes beyond their growth potential—it’s more about the diversification these markets provide to one’s portfolio.

In an increasingly globalized economy where correlations have spiked across markets over the past decade, frontier markets still provide access to equities with low correlations to broader, developed-market indexes.

3/15/2009 - 7/5/2013
S'P 500 1 0.773 0.474 0.852
MSCI EM 0.773 1 0.499 0.855
MSCI FM 0.474 0.499 1 0.470
MSCI EAFE 0.852 0.855 0.470 1


Looking at correlations since the markets bottomed out in March 2009 from the financial crisis of 2008 to July 5, 2013,  the MSCI Frontier Markets Index’s correlation to the S'P 500 Index has been 0.474.

In comparison, the popular MSCI Emerging Markets Index had a correlation of 0.773 relative to the S'P 500.

7/4/2003 - 7/5/2013
S'P 500 1 0.75 0.329 0.829
MSCI EM 0.750 1 0.374 0.875
MSCI FM 0.329 0.374 1 0.394
MSCI EAFE 0.829 0.875 0.394 1


Over a 10-year period, the frontier index’s correlation to the broad U.S. market has been 0.329. In comparison, the emerging markets index had a 0.75 correlation and the MSCI EAFE Index had an even higher correlation of 0.829 over the same time period.



Investing In Frontier Markets With ETFs

I’ve been a big fan of the iShares MSCI Frontier 100 ETF (FM) since its launch in September 2012. The fund holds 100 of the largest and most liquid securities from the aforementioned MSCI Frontier Markets Index.

I actually consider FM to be the first and only “pure” global frontier markets ETF in existence. Recently, it seems investors are catching on as well.

In a less than a year, FM has grown into a $210 million fund, much of that coming in the past few months. Considering that FM was only a $19 million fund at the start of the year, FM’s inflows have been impressive year-to-date.

2013 Total AUM ($M) Flows ($M) % of AUM
January 35.8 16.7 89
February 52.9 17.3 48
March 64.9 11.6 22
April 95.6 27.9 43
May 129.7 29.5 31
June 207.9 91.8 71


Some market watchers say those inflows may accelerate following the recent pullback in emerging markets. Instead of going back into funds such as the iShares MSCI Emerging Markets ETF (EEM) when they’re ready to again take on risk, some investors may instead judge the time to be right to own frontier markets.

My guess is that investors have caught on to the fund’s performance since inception, especially in light of the recent lackluster performance of emerging markets. Of course it’s easy to like a fund that’s been performing well, and past performance doesn’t mean the fund will outperform in the future.

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Total Returns - YTD


But as I mentioned earlier, FM’s draw has to do with correlations as much as past returns.



Structural Considerations

While I’m a fan of the FM, there are a few factors worth noting.

For starters, FM could look very different next year in terms of country exposure, due to the recent MSCI reclassifications of Qatar and UAE. Both countries were promoted to the MSCI Emerging Markets Index, though the changes won’t take place until May 2014.

I spoke about this in a previous blog , but in a nutshell, Qatar and UAE are currently the bigger fish in a small pond regarding market capitalization and liquidity. How difficult will it be for FM to find less liquid securities that currently don’t make the cut to replace those securities from Qatar and UAE? How FM goes about replacing those securities remains a big and unanswered question.

Also, it’s not clear what types of tax consequences will arise if the fund needs to sell and replace close to one-fifth of its portfolio.

Furthermore, is there a possibility that the methodology could be tweaked for FM if MSCI and iShares cannot reconfigure the index to have a sound investment product? After all, the MSCI Frontier 100 Index was custom-created for this iShares product.

These questions, again, are still unanswered and warrant close monitoring.

Will The Tail Wag The Dog?

Another big question is, Just how big can FM become? Even though FM’s index screens for liquidity and selects only the 100-most-accessible securities, it still targets certain markets that are still relatively illiquid.

FM rates only a 2 out of 5 in our IU/Knight Block Liquidity measure, which shows the ease of trading 25,000 shares through a liquidity provider. This low rating suggests FM is somewhat difficult and can be costly to trade in bulk.

One creation unit of FM—50,000 shares—also currently represents close to 1.70 percent of the underlying share volume—not horribly high considering it’s a frontier fund, but high enough to take note, according to our ETF Analytics underlying volume/unit measure.



While FM is still a $210 million fund, if it turns into a multibillion-dollar fund, I wonder if large creations/redemption in FM could eventually start driving the returns of its underlying assets.

Clearly, that’s not an ideal situation, and goes against what ETFs are supposed to do:track and follow an index. An ETF’s returns are supposed to be driven by the underlying securities, not the other way around.

In such a scenario, would iShares have to cap or halt creations? If that were to happen and demand stayed strong, the fund could then start trading at a premium to net asset value (NAV), potentially burning latecomers.

That said, I also can’t help but to point out that early investors in FM could actually take advantage of such a situation, as long as it’s understood that the returns are driven by a premium, not the fund's NAV.

Premiums and discounts should also be monitored because FM targets some smaller markets that are relatively inaccessible, including some markets with certain restrictions to foreign investors. Add in very little overlap with local exchanges and U.S. market hours, and it create difficulties for even authorized participants and issuers to create/redeem shares in a timely manner.

Concluding Thoughts

Despite these considerations, I think FM has a lot going for it.

Besides its potential for growth and lower correlations to the broader markets, FM’s indicated yield is also currently north of 2 percent, which should resonate with yield-hungry investors.

There’s certainly risk here, but again, just recall how risky emerging markets were in the early 2000s.

Bottom line:As I mentioned in an earlier blog, I fully expect FM to become the standard by which investors access frontier markets through an ETF wrapper.

At the time this article was written, the author held a long position in FM. Contact Dennis Hudachek at

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