Why iShares’ ‘FM’ Is About To Get Better

April 17, 2014

UAE and Qatar leaving iShares frontier ETF ‘FM’ poses problems, but will make the fund better.

It’s official: The iShares Frontier Markets 100 ETF (FM | D-94) is the new favorite developing-markets ETF.

While I always thought that FM would become the de facto way to play broad frontier markets through ETFs, I’m still surprised at its growth over the past 15 months. FM’s assets now stand at more than $700 million, 35 times more than the $19 million it had at the beginning of 2013.

Still, FM will go through a significant index change in the coming months that may lead to tax consequences, so it’s worth paying attention.

In May, Qatar and UAE will officially begin their departures from the MSCI Frontier Markets Index and their entries into the MSCI Emerging Markets Index. This means FM will eventually have to rid itself of 22 securities that currently make up more than 35 percent of the fund’s weighting.

A reconstitution of this magnitude may cause jitters, but my concerns are less about missing out on Qatar and UAE, and more about FM’s recent surge in share price and possible capital gains distributions.

Possible Tax Consequences

With the stock markets in Qatar and UAE having surged so much over the past year, my guess is that FM is sitting on some hefty unrealized gains.

iShares hasn’t publicly commented on how it will implement this transition yet, so turnover consequences may be on investors’ minds. That said, it’s also premature to assume the transition will automatically create massive capital gains distributions.

ETFs are different from mutual funds because they don’t have to sell securities directly from their holdings. Rather, authorized participants (APs) do most of the trading through the creation/redemption process.

According to MSCI’s most recent announcement, the phaseout will take place over seven months, on the last day of each month, starting in May and concluding in November.

iShares will likely use the creation/redemption process to wash out those FM positions over time to minimize any capital gains consequences. The fund company could do this by having APs use a different redemption basket from the creation basket during the transition.

The big concern would be if there aren’t enough redemptions. As you can see, it’s pretty much been a one-way street with inflows and creations over the past year.

FM Fund Flows

Source: ETF.com

If the massive inflows continue, that’ll make it difficult for FM to flush out those securities through the redemption process, possibly forcing the fund to directly sell its positions.

 

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