Frontier ETFs: the New Emerging Markets

ETFZone

Frontier markets deliver the wild ride emerging markets used to. Strong, uncorrelated returns with occasional big drops are standard for frontier countries.Although it is tempting to believe professionals can beat the index in inefficient and overlooked countries as Qatar or Angola, it is tricky and expensive business. ETFs simplify the process at vastly less expense.Expect better returns with frontier markets over time, just don't expect to predict when and where. During the past year, various frontier ETFs made emerging market (EEM) look stable:

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Higher risk is unwelcome in large amounts, but a small amount of frontier ETF will barely raise overall portfolio risk. This is because frontier markets tend to correlate poorly with developed ones which dominate portfolios. It's one of the few nearly free lunches available in investing. Correlations to watch out for are emerging markets and commodities, as most frontier markets today are propelled by natural resources. It may not pay to load up on all three asset classes.Claymore/BNY Mellon Frontier Markets ETF (NYSEArca:FRN - News) has perhaps the broadest of any frontier ETF. It provides solid exposure to 10 worthwhile countries such as Egypt, Colombia and Kazakhstan. Although it has high exposure to Chile at 31%, the February earthquake had surprisingly little effect. Fees are reasonable at 0.65%.SPDR S&P Emerging Middle East & Africa ETF (NYSEArca:GAF - News) has more narrow exposure than its name might imply. Almost 90% of holdings are from South Africa and Israel (probably better described as an emerging economy). GAF neglects Nigeria, Asia, or Gulf States, which would have made it more useful to the frontier investor.Africa is a traditional frontier region and increasingly attractive for investment. According to the International Monetary Fund's most recent economic survey, "one of the least noticed aspects of the global downturn has been the resilience of the sub-Saharan Africa region". Sub-Saharan output is projected to expand by nearly 5 percent in 2010, compared to 2 percent in 2009.Africa operates with little debt or securitization, so it mostly sidestepped the recent financial meltdown. Its natural resource economy is relatively diverse so it absorbed shocks to individual commodities. Just about every commodity is exported from there in meaningful amounts, from oil to diamonds to cocoa. China is building infrastructure to help goods move out of the interior. Corruption continues to siphon off growth potential.For African-only exposure, there is Van Eck Market Vectors Africa Index ETF (NYSEArca:AFK - News), with annual fees of 0.83%. It contains large amounts of South Africa, Nigeria, Morocco and Egypt. Some view South Africa as emerging, but its economy is tied to other African frontier markets. The iShares MSCI South Africa ETF (NYSEArca:EZA - News) allows direct exposure to that continent-leading country.Oil-rich states of the Persian Gulf and Middle East have traditionally done most of their business in privately held firms, but exchanges are gaining volume and accounting is becoming more transparent. Inefficiency and market manipulation remain issues.The Gulf and Middle East is represented by WisdomTree Middle East Dividend ETF (AMEX:GULF - News), with annual fees of 0.88%, and Van Eck Market Vectors Gulf States ETF (NYSEArca:MES - News), with annual fees of 0.98%.Eastern European and Asian nations form another frontier group. Many are former Soviet satellite states still dominated by Russia. Some have ample natural resources. The rule of thumb is that the farther from Western Europe, the slower market reforms have been.Some quite risky Eastern European countries may be found in SPDR S&P Emerging Europe ETF (NYSEArca:GUR - News), with annual fees of 0.6%. GUR has large exposure to Russia, whose Wild West atmosphere could easily put it in the frontier camp despite its superpower diplomatic status. 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.Finally, certain smaller Latin American countries with poorly developed exchanges and confiscatory tax policies languish in frontier status. Bolivia, Ecuador and Peru are often mentioned. Latin American region ETFs are dominated by relatively advanced economies such as Brazil. And individual country ETFs cover few of the riskier nations.Many frontier investors round out their pickings with country ETFs. Liquidity in country-specific ETFs might seem a concern but often not a problem. EZA, for instance, is far bigger than any other fund discussed in this report with $400 Million in assets.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.

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