New Frontier Market ETFs On Horizon

Another frontier market ETF is likely coming up, and not a moment too soon.

FTSE’s launch of its new frontier markets index series in September likely spells future competition for the popular iShares MSCI Frontier 100 ETF (FM | D-67).

For now, that iShares ETF has $731 million in assets and has solidified itself as the “go-to” broad frontier markets product. Since its launch in September 2012, FM’s had net inflows of $670 million on the back of blistering total returns of 49 percent through Oct. 31, 2014.

With no ETF filings yet on these new FTSE indexes, you might be asking why this index launch is even relevant.

It’s relevant because FTSE and MSCI are the two indexing giants in the international space, and I think it’s only a matter of time before we get a FTSE frontier ETF. Interest in frontier markets will grow in the coming years, and there’s going to be much debate on the definition of “frontier markets.”

Another ETF Is Needed

MSCI and FTSE differ in their criteria for frontier classification, which I won’t get into the details of here. But because they do differ, I think there’s a real need for another broad frontier markets ETF besides iShares’ FM.

(The Guggenheim Frontier Markets ETF (FRN | D-18), an American depositary receipt/global depositary receipt-exclusive ETF also exists, but BNY Mellon is alone in classifying Chile, Colombia, Egypt and Peru—67 percent of FRN’s weighting combined—as frontier instead of emerging. So I’m going to exclude FRN from this discussion).

A new FTSE frontier ETF would not be another “me too” frontier fund, but would provide something new and different from the current MSCI-based FM.

So before you say “who cares?”, let’s look at why FTSE launched this new index series and how FTSE’s frontier index differs from MSCI’s.

Availability and Flexibility

To be clear, the “investable” FTSE Frontier 50 Index, consisting of the 50 largest and most liquid securities from frontier markets, has existed for years. The term “investable” is important here because broad frontier markets aren’t fully investable in an ETF wrapper due to liquidity and accessibility issues.

Separately, FTSE’s new indexes are comprehensive frontier market indices that complement and roll up into FTSE’s flagship Global Equity Index Series (GEIS).

I recently caught up with Brad Zucker, an ETP product analyst at FTSE who was involved in the creation of these indexes.

He summed it up by saying, “With the launch of this frontier index series, we now have the availability and the flexibility to build more suitable products for ETF providers in particular.”

In other words, these new indexes create a base from which issuers can work with FTSE to create their own customized broad frontier indexes for ETF products.

Even iShares worked with MSCI to create the MSCI Frontier 100 Index for FM—which takes into account liquidity screenings—from MSCI’s broader frontier-markets parent index.

FTSE Vs. MSCI: Kuwait, Qatar & Pakistan

It’s unlikely we’ll see a redux of the EEM versus VWO battle when a FTSE frontier ETF launches.

Vanguard’s and MSCI’s battle was largely fought over costs and tracking, with differences usually in the tens, and sometimes, hundreds of basis points between the iShares MSCI Emerging Markets ETF (EEM | B-97) and the Vanguard FTSE Emerging Markets ETF (VWO | C-89).

The battle between frontier ETFs will be more top down, based on radically different country exposures, which would likely result in performance differences in the hundreds, if not thousands, of basis points.

So what are the most significant differences between MSCI’s and FTSE’s frontier indexes?

For now, it mostly comes down to Kuwait, Qatar and Pakistan, though in the near future, additional major changes are in store.

Kuwait is currently an unclassified country in FTSE’s eyes, but it’s under review for direct inclusion into its emerging markets index, meaning it will likely bypass frontier altogether. Yet Kuwaiti securities currently comprise 23 percent of the MSCI Frontier IMI Index.

Part of the reason Kuwait is such a heavyweight in MSCI’s index is because it recently bumped UAE and Qatar out of frontier to emerging status. Meanwhile, Qatar has a strong foothold in FTSE’s frontier index.

Swapping Gulf States

So in essence, with FTSE, you’re swapping out one major Gulf State (Kuwait) with another (Qatar) compared with MSCI.

Pakistan is another big difference. It’s currently MSCI’s fourth-largest country weighting at 7 percent, but FTSE has long reclassified Pakistan as emerging, meaning it’s excluded in FTSE’s frontier indexes.

Finally, a major upcoming FTSE change involves Argentina. FTSE recently demoted Argentina from frontier to “unclassified” in September, meaning Argentine securities are set to leave the index in June 2015.

Argentina currently makes up 15 percent and 7 percent in FTSE and MSCI, respectively. By the time we get a FTSE frontier ETF, it’s possible Argentina would not even be included.

Looking Ahead For Frontier ETFs

Years from now, I think 2013 and 2014 will be remembered as breakout years for frontier markets in terms of its legitimacy as an investment asset class, similar to the way 2003 was the breakout year for emerging market ETFs.

The frontier market genie is clearly out of the bottle, and it’s not going to be whisked away anytime soon.

Unfortunately, the conundrum of defining frontier markets will be ongoing. Furthermore, investors will need to monitor annual country classification reviews because countries will be upgraded and downgraded as they mature or deal with geopolitical setbacks.

Having more frontier market ETF options will be a good thing. A new FTSE frontier ETF will give investors more control and the ability to decide for themselves whether they favor MSCI’s or FTSE’s definition of frontier markets.

At the time this article was written, the author held no positions in the securities mentioned. Contact Dennis Hudachek at [email protected], or follow him on Twitter @Dennis_Hudachek.