Past few months have been quite ugly for emerging market ETFs. The start of QE tapering coupled with slowing growth in China has made foreign investors nervous about these investments.
Even though emerging markets may stabilize after the current round of panic subsides, they may not regain their past glory any time soon. As major emerging economies are beginning to mature and slow-down, they will no longer able to repeat their stellar performance seen not that long ago.(Read: Best ETF Startegies for 2014)
Investors looking for the “next big thing” in the investing world are now turning to “frontier” or “pre-emerging” markets. These countries offer compelling investment opportunities with solid growth potential and low valuations.
The MSCI frontier markets index surged about 26% last year while the emerging markets index plunged more than 3%. The outperformance continues this year as well.(Read: 3 Top Ranked ETFs that will crush the market in 2014)
What are Frontier Markets?
Although there is no strict definition for frontier markets, these are typically countries that are in the earlier stages of economic development. Their capital markets are underdeveloped and not fully/easily accessible to foreign investors.
The term “Frontier Markets” was first used by the International Finance Corporation to describe a set of small, illiquid and underdeveloped markets. Now MSCI, S&P and Russell have their own definitions of “Frontier Markets”. (Read: Emerging Market ETFs: Any Bright Spots?)
MSCI Frontier Markets Index currently includes 34 countries. Most of these countries are in Middle East, sub-Saharan Africa, Southeast Asia, Latin America or Eastern Europe regions.
Why Frontier Markets?
Frontier markets are expected to grow faster than emerging and developed economies. Further, they have relatively lower valuations as well as higher income yield.
As emerging markets have become increasingly integrated with the global markets, their correlations with the developed markets have increased and the benefits of diversification have declined.
On the other hand, frontier markets still have relatively lower correlations with the developed markets. Further, most of them were not did not see major foreign investment inflows in the past few years and thus are less vulnerable to QE taper. Thus adding them as small satellite holdings in an investment portfolio can improve risk-adjusted returns over long term.
Currency Factor in Performance
One of the reasons for outperformance of frontier markets is the currency factor. Some of the frontier markets—which saw strong performance in 2013 as well as this year—peg their currencies to the US dollar or to a basket dominated by the US dollar.
As such these currencies have remained steady while currencies of most emerging markets have suffered a lot of pain. Currency losses have been a big factor is emerging markets’ poor performance.
What are the Risks?
Before considering frontier market investments, investors need to be aware of liquidity and political risks of investing in these countries as they are much riskier even compared with most emerging markets. But risk-tolerant investors are likely to reap significant rewards in the long-term.
Below we have highlighted some of the options available to investors in this space.
Companies in the Gulf region have been reporting strong earnings in the past few years and property markets have shown improvement of late. Last year, MSCI upgraded UAE and Qatar to emerging market status from frontier market. The upgrade is expected to result in massive increase in capital flows to the region. (Read: Can Gulf ETFs keep glowing?)
Due to expansionary fiscal policies and low interest rates, economic activity has remained steady in recent years. Per IMF, Qatar will grow at 5% this year, while Saudi Arabia and the UAE will grow about 4%.
UAE and Qatar peg their currencies to the US dollar and while Kuwait pegs its currency to a basket of currencies, the basket is believed to be heavily weighted towards the greenback. As a result these currencies have remained rather stable.
Market Vectors Gulf States Index ETF Fundamentals and WisdomTree Middle East Dividend Fund (GULF - Free Report) are the two options available to investors.
Vietnam continues to be the main beneficiary of the migration of low-end manufacturing out of China as the producers try to take advantage of wages that are about half of that in China. The shift in China’s policy to focus more on domestic consumption will also benefit Vietnam as an outsourcing center.
A pickup in developed economies is good for the country as they account for about half of country’s exports, mainly apparel and electronics. Van Eck Market Vectors Vietnam ETF (VNM) is the only ETF option available to investors to access Vietnam’s equity markets.
Broad Frontier Market ETFs
Guggenheim Frontier Markets ETF (FRN) seeks to match the performance of the BNY Mellon New Frontier DR Index. BNY Mellon defines frontier market countries based on the GDP growth, per capita income growth, inflation rate, privatization of infrastructure and social inequalities.
However the top countries included in the ETF—Chile (43%), Colombia (15%), Egypt (11%) and Peru (9%)--which account for about 78% of the holdings are “emerging” markets” and not “frontier” markets per MSCI and S&P.
PowerShares MENA Frontier Countries ETF (PMNA) tracks the performance of liquid companies in MENA (Middle East and North Africa. This fund is being closed on February 18, 2014.
iShares MSCI Frontier 100 Index (FM - Free Report) tracks the MSCI Frontier Markets Index, which is dominated by Gulf states--with Kuwait (28%), Qatar (17%), and the UAE (11%) in the three spots out of top four, with Nigeria (13%). But remember, Qatar and UAE will be out of the frontier market index in a few months.
Want the latest recommendations from Zacks Investment Research? Today, you can download7 Best Stocks for the Next 30 Days.Click to get this free report >>