Investors Overlooking Frontier ETFs?

ETF.com

There has been much debate about the impact of quantitative easing and what winding it down will do to emerging markets. At the same time, little has been said about the state of frontier markets.

Investors can be forgiven if frontier markets aren’t at the top of their minds these days. After all, it’s hard enough to read the tea leaves with the current “he-said-she-said” slap fight going on in Washington, D.C.

Further, it wasn’t until recently that investors began allocating significant pockets of their asset allocation to international markets, let alone segmenting them into developed, emerging and frontier baskets.

Still, there’s a reason the Vanguard FTSE Emerging Markets ETF (VWO | B-86) and the iShares MSCI Emerging Markets (EEM | B-97) have nearly $100 billion in combined assets:Investors now think about their international equity exposure in terms of economic development level. And yet, the performance of the two largest frontier markets ETFs—the iShares MSCI Frontier 100 ETF (FM | D-93) and the Market Vectors Vietnam ETF (VNM | B-33)—has outpaced that of the broad emerging markets space.

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FM_VNM_VWO_EEM_YTD_performance

Chart courtesy of StockCharts.com

Furthermore, investors use the ETF wrapper as their de facto tool for getting emerging markets exposure. While this is very much a positive development, the reality is the frontier markets of the world still occupy the periphery of investor consciousness.

What else could explain the fact that less than $500 million is currently invested in just three “total market” frontier ETFs? There are currently 130 different emerging market ETFs, targeting everything from single-country small-caps to infrastructure. By comparison, there are just nine frontier market ETFs, with combined assets of less than $1 billion.

Some of this has to do with investability, of course. At the top of the emerging markets food chain are countries like Brazil, China and—depending on who you ask—Korea.

These markets are home to massive multinational companies. The sheer size of these markets provides the capacity needed to allow for stable, liquid index products. In fact, China is now the second-largest economy on Earth, and closing in fast on the United States.

Investors would do well to remember that the developed, emerging or frontier label doesn’t refer to an economy’s size, but rather to things like capital restrictions, currency controls and political stability.

Frontier markets, on the other hand, are decidedly smaller, even if that’s not the means used to classify them as such. The full market cap of Vietnam is just over $30 billion, and nobody in their right mind would call Bulgaria or Serbia global economic powers.

Still, it’s surprising to see so little attention paid to a pocket of the market where so much of the world’s low-cost manufacturing and production is being shifted.

 

It could be that investors are unwilling to pay the cost of doing business in these countries until it proves to be more cost effective or the places graduate to emerging markets.

To prove this point, even MSCI—perhaps the world’s foremost authority on international index design—had to jump through some hoops in order to build a practical frontier markets index. The MSCI Frontier Markets 100 Index has substantive liquidity screens and a cap on country weights.

The iShares MSCI Frontier 100 ETF has just $325 million in assets and trades less than $5 million most days, with an average bid/ask spread of 34 basis points. When combined with the fund’s 79 basis point expense ratio, the cost to access the fund eclipses 100 basis points, or $100 for each $10,000 invested.

That’s a massive hurdle for investors to overcome, especially when all available evidence tells us that the key to long-term investment success is minimizing costs.

To show just how expensive it is to access these stocks, consider this:Despite the fact that FM holds just 100 stocks screened specifically for their liquidity and foreign ownership eligibility, one 50,000-share creation unit represents nearly 2.5 percent of the average daily dollar volume in those stocks.

When the dominant Middle Eastern countries at the top of its holdings list—Qatar and the UAE—are reclassified as emerging market countries in 2014, these challenges will only intensify.

Even the Market Vectors Vietnam ETF (VNM | B-34)—which has managed to attract north of $300 million in assets—is a tricky way to access the Vietnamese market. The fund has nearly $5 million in trading volume most days, but one 50,000-share creation unit of VNM represents more than 7 percent of the underlying volume in the 25 holdings in the portfolio.

This reality means regardless of how attractive frontier markets may be, the friction associated with accessing them may a bridge too far.

Still, the performance of frontier markets has been fantastic. Investors should therefore keep the frontier markets in mind, despite their shortcomings. Many of these markets represent the future of funds like VWO and EEM as they graduate to emerging markets status, and their economic ascension will play a large role in shaping the future of the world’s economy.

In short, frontier markets stocks are expensive to access and hard to manage. But that’s not to say they’re irrelevant.


At the time this article was written, the author held no positions in the securities mentioned. Contact Paul Baiocchi at pbaiocchi@indexuniverse.com, and follow him on his Twitter handle, @BaiocchiPaul.


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