Your emerging-market portfolio is about to get a bit more “exotic.”
Many fund sponsors have begun issuing new exchange-traded funds (ETFs) for faraway lands like Saudi Arabia and Sri Lanka. These and other such up-and-coming locales have been dubbed “frontier markets” by Wall Street and are found outside traditional emerging-market funds like the iShares MSCI Emerging Markets Index (EEM).
Characterized by very fast-growing economies and very small or hardly existent equity markets, these frontier markets aren’t known tourist hotspots, but they feature all the hallmarks of early emerging-market superstars … including a hefty dose of volatility. Still, these emerging markets that haven’t quite fully emerged could offer some of the best long term returns around.
So if you’re looking for growth from the international part of your portfolio, consider these ways of getting frontier markets to work for you.
Frontier Markets: Plenty of Rewards
The problem for many traditional emerging markets such as China and India is that they’re really not emerging anymore. Growth has slowed, and worse, many of these emerging economies have become so interlinked with the developed world that their stock markets have lost some of their ability to outperform other major courses. China is the United States’ largest trading partner, the bulk of Russian natural gas production flows towards Europe … and so on.
At this point, many developing economies only offer a fraction of their historical benefits. Fellow InvestorPlace contributor Daniel Putnam makes a compelling case to drop your EM exposure altogether. While I’m not as bearish on EMs as Putnam and still believe that quality companies can be found everywhere, he does make a major point on correlations between the developed and developing world.
Which is why investors should take a look at frontier markets.
Nations like Uganda, Croatia and Kazakhstan all offer lower correlations to other asset classes. Putnam points out that the over the last 10 years, the MSCI Emerging Markets Index has had a correlation of around 0.8 with the S&P 500. That number rises to 0.9 when comparing it to the MSCI Developed Markets Index.
However, during the same time period, the MSCI Frontier Markets Index — which tracks stocks in places like Nigeria, Pakistan and Bangladesh — showed just a 0.329 correlation with the S&P 500. Perhaps more importantly, the frontier markets index only managed to produce a 0.374 correlation with more “developed” emerging-market sisters.
In plain English, that means frontier markets provide plenty of “zig” when the broader markets “zag.”
For instance, last year, the MSCI Frontier Markets Index gained roughly 16% … at the same time more traditional emerging markets produced a whopping 12% loss.
And there’s more to love than lack of correlation.
Many of these frontier markets feature some of the most attractive demographics around. According to HSBC, frontier markets encompass a population base of 1.2 billion people, or more than a fifth of the world’s population. The kicker? The median age for that 1.2 billion people is just 30.2 years!
Secondly, the frontier is rich with commodities and natural resources. Many of the most recent mammoth finds in oil, gold and other commodities have occurred within these frontier countries. While the short-term picture for natural resources is a bit blurry, longer-term, we still need these things to prosper.
In a nutshell, frontier markets are packed with growth prospects.
Just Don’t Forget the Risks
You don’t get something for nothing. In addition to growth, the hallmarks of many of these nations include…
- Political instability
- Inadequate regulation
- Substandard financial reporting
- Poor equity markets liquidity
- Large currency fluctuations
As you’d imagine, that leads to some pretty high volatility.
The Market Vectors Egypt Index ETF (EGPT) is the poster child for this. The EGPT fund has seen huge swings on the back of rising economic growth, protests, a forced change in government leadership and a return to something resembling normalcy.
The below chart shows just how crazy EGPT’s swings have been since its inception in 2010.
How to Buy Frontier Markets
Given the risks and sheer difficulty of accessing frontier markets on a single-stock basis — Panama’s Banco Latino Americano de Comercio Exterior (BLX) is one of a handful of FM stocks that trade on U.S. exchanges — ETFs make tackling these nations a little easier.
Currently, there are nine ETFs that invest in frontier markets. These include providing exposure to the Middle East via the WisdomTree Middle East Dividend (GULF), or Africa via Global X Nigeria Index ETF (NGE). And there are many more on the way. Plans are in the works to create funds that track Slovakia, Kuwait and even Morocco.
You can certainly make the case for betting on one of these regional or single-nation funds. However, broader might be best.
The iShares MSCI Frontier Markets 100 (FM) tracks 101 different frontier-market stocks from a host of different nations and basically provides exposure to aforementioned mentioned frontier-market index. The nice thing about all that broad exposure is that one despot isn’t going to bring the whole thing tumbling down.
So far, FM’s non-correlated nature has worked perfectly; the iShares ETF produced a 26% gain last year vs. EEM’s loss. Those gains have continued into 2014 as FM is up about 2% year-to-date.
FM isn’t necessarily a cheap ETF, charging 0.79%, or $79 annually on ever $10,000 invested. However, given just how hard some of these places are to reach, that expense ratio is actually quite cheap. And as the fund gathers assets — already it’s proving to be a hit — iShares should bring that down.
The case for going into the frontier is very persuasive. FM is my favorite way to do it.
As of this writing, Aaron Levitt was long FM.