Hougan: 2 Key Frontier Market Facts

MSCI will switch UAE and Qatar from frontier to emerging markets.

MSCI will switch UAE and Qatar from frontier to emerging markets.

Frontier markets—and specifically, the iShares MSCI Frontier Markets 100 ETF (FM | D-93)—are the hot thing right now.

Investors sunk $380 million into FM in 2013, and amazingly, continued investing in them in January 2014. Despite a massive pullback in global equity markets and $15 billion in net outflows from equity ETFs, investors sunk $50 million in net new money into FM for the month.

It’s easy to see why. FM is one of the few equity ETFs to post positive returns in 2014. Year-to-date through Feb. 7, the fund was up 1.39 percent for the year, compared with a 2.71 percent drop in the S&P 500 SPDRs (SPY | A-97) and a 7.33 percent pullback in the iShares MSCI Emerging Markets ETF (EEM | B-100).

Chart courtesy of StockCharts.com

I love the idea of investing in frontier markets. Many emerging market economies appear to be exiting the hypergrowth phase investors have enjoyed for the past decade. They’re becoming more correlated with developed markets. Frontier is the natural next place to look for both growth and diversification.

But before we get too excited about frontier markets in general and FM in specific, there are two important things to understand.

Point 1: Frontier Markets Are Not What You Think

When I think of frontier markets, I think of underdeveloped economies with young populations and enormous potential. I think of places like Ghana, where the median age is 20 and the economy is growing by a staggering 8 percent per year.

The so-called Switzerland of Africa is attracting significant foreign investment and recently completed a very close democratic election that was nonetheless generally accepted as fair by the population. Its GDP per capita is $1,604.

I don’t tend to think that way of the United Arab Emirates, which produces more than $40,000 in GDP per capita and has an average life expectancy nearly equal that of the U.S. And I definitely don’t think like that about Qatar, where the GDP per capita is north of $100,000 and where 14 percent of the population are millionaires.

But for MSCI—the index provider behind FM—both countries count as frontier (for now). In fact, 56 percent of FM’s currently portfolio is focused on Gulf countries, headlined by a 21.13 percent allocation to Kuwait and a 17.72 percent allocation to Qatar.

MSCI has good reasons for this. The criteria for differentiating “frontier” from “emerging markets” include economic as well as investment factors. While places like the UAE are developed by most economic standards, their capital markets face restrictions and clearing delays that have historically placed them into the frontier bucket.

My sense is investors know this in general. They know that a term like “frontier” casts a wide net. But I’m not sure they know that net captures both Qatar (the second-richest country in the world, after Luxembourg) and Bangladesh (#157 out of 184).

Investors should know that right now FM is largely a bet on Middle Eastern banks, with some fast-growing African nations held on the side.

Point 2: This Bet On The Middle East Has Been Great For Returns … And Is Changing Dramatically In May

The other thing investors should know is that they’ve been rewarded famously well for making this bet on Gulf countries.

An overwhelming majority of the strong performance in FM in 2013 can be traced to the strong weights in Qatar and the United Arab Emirates. Stocks in the UAE rose 74.91 percent in the past year, while Qatar posted a healthy 25.83 percent gain.

Outside of these two big winners, a look at the country-specific returns of the top 10 country weights in FM shows a mixed bag. For all the great returns in Kenya and Pakistan, you have terrible returns in Nigeria, Morocco and Kazakhstan. That’s about what you’d expect: Real frontier countries are heterogeneous, with significant exogenous risks that can shock returns dramatically (coups, wars, natural disasters, etc.).

The kicker here is that, in May, both Qatar and the United Arab Emirates will graduate from “frontier” to “emerging markets” in the MSCI system. As a result, they will be kicked out of FM. That’s 31 percent of the portfolio and the biggest driver of recent returns.

The resulting portfolio will look a lot different.

Outside of Kuwait—the 11^th-richest country in the world on a per capita basis—the “new FM” will look more like a true frontier market portfolio, with big weights in countries like Nigeria, Argentina, Pakistan and Kenya.

In fact, the rebalance will cut the weighted average GDP per capita of the portfolio essentially in half: from $37,667 to $19,123, using IMF data.

In a sense, that’s a good thing: Investors will get more of what they think they want.

The question is, When they see what that means to their portfolio, will they actually like it?

At the time this article was written, the author held no positions in the securities mentioned. Contact Matt Hougan at [email protected].