Investors focused on the developing world who are looking to further diversify their portfolios are reaching further into frontier markets via funds such as “FM,” while pulling assets out of popular emerging market vehicles, including EEM and VWO, in a possible sign of a shift in investor sentiment.
The iShares MSCI Frontier 100 ETF (FM), which started the year with $35.8 million, has gathered $264 million year-to-date, and is now a $275 million fund. At the same time, the iShares MSCI Emerging Markets ETF (EEM) has bled $7.72 billion, and is now a $35 billion fund, after starting the year with $48.2 billion, according to data compiled by IndexUniverse.
The divergent flows on the two funds are confirmed in the realm of returns as well, with FM rising 16 percent this year, while EEM has fallen 12 percent, according to data compiled by IndexUniverse. For the record, the Vanguard FTSE Emerging Markets (VWO) has had outflows of $3.1 billion and, like EEM, has fallen about 12 percent.
The shift in investor sentiment began in earnest in the wake of Fed Chairman Ben Bernanke’s “tapering” comments on May 22. The signal sent chills through investment markets that have come to rely on the U.S. Central Bank’s easy-money policies to fuel upward momentum in asset prices. Emerging markets have been especially hard hit, and it remains to be seen whether the allure of frontier markets has longer-term legs. The tapering could come as soon as next month.
A recent report from Bank of America Merrill Lynch showed that while some $2.1 billion exited emerging market funds from January to mid-August, frontier market funds saw inflows of $1.5 billion in the same period, according to CNBC.
But is this a sign of better things to come for frontier markets and the funds that have exposure to them?
“No one really knows,” said Dennis Hudachek, an ETF analyst at IndexUniverse, who at the least sees it as a sign of investors sniffing out the possibilities of alternatives to emerging markets, which have had a good run for the past decade or so.
“But there has been a tremendous amount of money that’s poured into these larger emerging market economies over the last 10 years, and correlations have also spiked with broader markets here, whereas a lot of frontier markets have been relatively untapped and a lot of investors haven’t really invested in these markets,” he added.
Frontier Bulls, Emerging Bears
Putting a finer point on the divergent returns, Hudachek said the most prominent frontier market holdings in FM—Kuwait, Qatar and the United Arab Emirates—are absolutely on fire this year.
“Kuwait is up 35 percent and UAE is up more than 40 percent, and Kuwait makes up more than 30 percent of the weighting in FM,” he noted.
In a recent interview with IndexUniverse, ConvergEx Group’s Chief Market Strategist Nicholas Colas said that while frontier markets present investors with “acres and acres of risk,” not a lot of emerging markets can give them the potential for 7-10 percent growth structurally as frontier markets can.
Indeed, Hudachek underscored the fact that many of the most-well-known emerging markets countries—such as Taiwan and the BRIC countries—have “absolutely gone nowhere” in terms of performance, or have fallen sharply.
“China has basically been flat, Brazil is down almost 20 percent, Russia is down almost 7 percent and India is down 8 percent,” Hudachek said.
He noted that U.S. investors in VWO and EEM also have to contend with local currency exposure because these funds are not hedged.
“The Indonesian rupiah is down almost 10 percent in just the last few months, so you’ve got the underlying markets getting hit really hard, plus the currency factor that’s exacerbating the sell-off,” he said.
FM’s Uncertain Future
Singling out Qatar and UAE is appropriate to the extent that they are two huge constituents in the fund that won’t be part of it by spring of next year.
Together they make up about a third of the portfolio market value, and their combined 20 stocks make up a fifth of the fund’s 100 holdings.
The problem is that MSCI promoted both to its Emerging Markets Index, effective May 2014, raising all manner of questions about the viability of the fund once they’re out of its portfolio.
“If they still track that index, and assuming no change in methodology, the securities of those countries are going to have to move out of FM. Being that this index was created for this iShares product, I wouldn’t be surprised if they maybe tweak the methodology,” Hudachek said.
"No one knows right now because iShares isn’t talking about it but this is something that people invested in FM should keep in mind,” he added.
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