Too significant to ignore

Exchange-traded funds (ETFs) linked to frontier markets present an enticing proposition for investors. Inherently a long-term investment opportunity, they not only offer potential for strong returns, but also provide an ideal means of portfolio diversification.

Frontier markets are “too significant to ignore”, according to Tim Drinkall, Executive Director, Morgan Stanley.

Frontier markets – a term attributed to economist Farida Khambata of the International Finance Corporation – are a subset of emerging market nations which are typically at an earlier stage of economic, political and financial development.

The grouping encompasses whole swathes of the developing world, including countries such as Argentina, Bangladesh, Croatia, Kenya, Nigeria, Qatar, Romania, Sri Lanka, United Arab Emirates (UAE) and Vietnam.

The rationale for investing in frontier markets is strong. They have a combined economy equivalent to approximately 6% of the world’s nominal GDP and comprise 22% of the world’s population, of which almost 60% is under 30 years of age. Natural resources are abundant and labour costs are extremely competitive.

The demographics, in terms of working-age populations, are particularly conducive to high rates of economic growth, as Mansoor Dailami, Manager of International Finance and Development Economics at the World Bank, notes: “By 2040, frontier markets will have a ratio of 5.7 (working-age to old-age people), while emerging markets will be at 3.4. Frontier markets have the potential to reap the rewards of the demographic dividend—a lengthy period of rapid economic growth and development.”

Tim Drinkall, Executive Director, Morgan Stanley Investment Management, argues that such a growth potential cannot be missed: “For 2011 to 2015, we believe frontier market economies can sustain a compounded growth rate of 4.3 percent. At that pace, frontier market countries could add an estimated $1 trillion in GDP over the next five years, while their total population is expected to grow by more than 78 million over the same period. This opportunity is too significant to ignore.”

In a global macro environment dominated by sluggish growth in the developed world, a slowing China and frequent bouts of market contagion, frontier markets’ low correlation with global markets also offers investors extensive diversification benefits.

Andrew Brudenell, Senior Portfolio Manager at HSBC Global Asset Management, says: “If you are diversified across the entire frontier markets asset class, this has been shown to have a lower correlation with developed market equities than the emerging markets space. It also has lower volatility, because although each individual country is quite volatile, the correlations between the countries within frontier markets themselves are very low.”

A number of ETFs offer access to this opportunity including the db X-trackers S&P Select Frontier UCITS ETF (XSFR) and RBS Market Access MSCI Frontier Markets Index ETF (M9SY) aimed at European investors and the iShares MSCI Frontier 100 Index ETF (FM) and Guggenheim Frontier Markets ETF (FRN) aimed at US-based investors.

The db X-trackers S&P Select Frontier ETF from Deutsche Asset & Wealth Management, part of Deutsche Bank, is probably the best ETF for everyday investors based in the UK and Continental Europe. The fund is cross-listed on a number of European exchanges including the London Stock Exchange, Deutsche Börse, SIX Swiss and Borsa Italiana and has as assets of more than $42 million. It is linked to the S&P Select Frontier Index, an adjusted market-cap weighted index comprising the largest and most liquid frontier market stocks. Constituents include listings in London, Hong Kong and New York and local listings from market generally accessible to foreign investors. The fund comes with a total expense ratio (TER) of 0.95%.

To ensure that the fund is liquid, diversified and easily tradeable, the underlying index includes a variety of eligibility screens. For example, a stock must have a minimum free float market capitalisation of $100 million, an average daily value traded over six months greater than $2 million, and a minimum of 15 days traded over each of the previous six months. Stocks which have reached their foreign investment limit (many frontier market countries impose stringent caps) as on each rebalancing are excluded. The top 40 stocks ranked by market capitalisation that meet these inclusion criteria are chosen for the index, subject to the constraint that a maximum of five stocks from any particular country can be included and that no country has a weight over 30% and no stock has a weight more than 10%.

Once these screens have been applied the index ends up with constituents from 13 different countries, the top five of which are currently UAE, Kuwait, Argentina, Qatar, and Panama. Nigeria, Pakistan and Kazakhstan also feature strongly. As is typically of frontier markets, the financials sector has the largest weight, representing approximately 44%, followed by industrials (21%) and materials (9%). Major holdings include Persian Gulf real estate developer Emaar Properties, Panamanian airline carrier Copa Holdings, Latin American eBay-equivalent MercadoLibre, Qatari chemical manufacturer Industries Qatar, and Kuwait’s first local bank National Bank of Kuwait.

Amenable MENA

An intriguing investable subset of frontier markets (some countries cross over into emerging market status) is the Middle East & North Africa (MENA) region. While many investors have been spooked, understandably, by the political unrest plaguing the region, a shrewd investor may see this as a rare opportunity to get in at an even lower price than usual: many of the Middle Eastern countries rocked by political unrest over the past year or so were some of the best farers during the 2007-2008 crunch, coming out of the crisis with strong growth rates.

Qatar alone posted 12% GDP growth in 2009, a number that had risen to nearly 19% by 2011 (and Qatar also remained relatively insulated from the political unrest that rocked much of the rest of the region). To be sure, investors should expect continued instability for the next couple years from a handful of lower-ranked constituents, even then, these countries, and certainly the region as a whole, is something to go long on over the long term.

Governments across the MENA region are investing in infrastructure, and a youthful middle class is emerging with a taste for consumer goods of all kinds – and this is creating new opportunities for companies. In the case of the UAE, the economy continues to rebound strongly, driven in particular by sectors such as tourism and real estate. These areas have recently seen strong inflows from overseas markets due to recent unrest in countries such as Egypt (an emerging market), and this has been generally encouraging for companies linked to these sectors.

So what are the funds operating in this space? The longest established is the NYSE Arca-listed PowerShares MENA Frontier Countries Portfolio ETF (PMNA), which tracks the Nasdaq OMX Middle East North Africa Index. It launched in July 2008. While that’s typically aimed at US investors, a European equivalent of the fund, the PowerShares Middle East North Africa Nasdaq OMX ETF (PSM), is listed on the Borsa Italiana and Euronext Paris. The underlying index covers Egypt, Morocco, Oman, Lebanon, Jordan, Kuwait, Bahrain, Qatar, Saudi Arabia, Tunisia and United Arab Emirates. An alternative for European investors is the Deutsche Börse and Euronext Amesterdam-listed RBS Market Access MSCI GCC Countries ex Saudi Arabia Top 50 Capped Index ETF (M9S0). This fund provides exposure to a chunk of the region, including Kuwait, Qatar, the United Arab Emirates, Oman and Bahrain.

While all these funds – both those tracking frontier markets in general and those focused on MENA – performed poorly during the financial crisis and have endured a rocky time for most of the period since, they are beginning to show signs of life. The db X-trackers S&P Select Frontier UCITS ETF and iShares MSCI Frontier 100 Index ETF, for example, are up 12.9% and 8.3% year-to-date respectively. But, to a certain extent, the short-term performance of these funds is irrelevant; the real opportunity lies over the long term.

Of course, as is the case with all investments, frontier markets and MENA equities are not without risk, and can be prone to political interference and currency risk. However, within a well diversified portfolio, these risks may be mitigated, allowing investors to benefit from what Morgan Stanley’s Drinkall calls an opportunity “too significant to ignore.”

(Rasheed Hammouda contributed to this article.)