Why iShares’ ‘FM’ Is About To Get Better

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

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.

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.

FM’s Recent Performance Concerns

Currently, more than 55 percent of FM is weighted in just three Gulf states: Kuwait, Qatar and the United Arab Emirates.

I’ve had mixed feelings about FM’s concentration to the Middle East.

On the one hand, FM’s strong performance can be attributed to the Gulf states, where local stock markets have been on a tear over the past year.

Just look at the returns of Qatar and UAE over the past year:

Source: Bloomberg

On the other hand, being too concentrated in one region can work against you if the tide turns on that region. Additionally, if I wanted to play the Gulf states, there are two pure-play ETFs already: the $68 million WisdomTree Middle East Dividend ETF (GULF | F-91) and the $29 million Market Vectors Gulf States ETF (MES | F-68).

I also wonder how much of this performance has been attributed to anticipation of Qatari and UAE securities being included in the $36 billion iShares MSCI Emerging Markets ETF (EEM | B-100).

Looking ahead, I only hope investors chasing returns and piling into FM at the moment don’t have unrealistic expectations post-transition.

FM, Post-Transition

As expected, MSCI is tweaking its methodology.

For starters, it’ll cap the top two countries at 40 percent combined, in order to stop Kuwait (and Nigeria) from having a disproportionate weighting once UAE and Qatar are taken out.

The new FM will also pull its constituents from the MSCI Frontier Markets Investable Market Index (IMI), which includes small-caps. The new methodology also allows the index constituents to fluctuate between 85 and 115 holdings.

Here’s a comparison of country weightings pre- and post-transition (estimated):

Source: iShares and MSCI

Even more interesting is the new regional exposures. Specifically, as Middle East exposure diminishes, Africa and Asia-Pacific will carry more weight.

Post-transition, I expect FM to become a more diversified, global frontier markets ETF.

Beyond its performance, I still consider the main draw of FM to be the diversification it provides in a portfolio, because frontier markets tend to be less correlated with global markets.

With regard to investor interest, I also think the frontier markets genie is now out of the bottle, and iShares likely already solidified its position in the frontier ETF landscape with FM. I only expect this to continue in the coming years.

At the time this article was written, the author held a long position in FM. Contact Dennis Hudachek at [email protected], or follow him on Twitter @Dennis_Hudachek.