Investing In The Frontier

[This article appears in our August 2018 issue of ETF Report.]

In 2014, frontier markets had a brief moment in the sun, as high-flying returns from smaller, riskier countries like Vietnam and the United Arab Emirates ignited investors' imaginations.

Since then, however, interest in frontier markets has all but evaporated, and they remain an obscurity to most investors.

However, there's still plenty to love about frontier markets—particularly their potential for juicy, outsized returns long term.   

Frontier markets are "like deep value investing," said Perth Tolle, founder of Life + Liberty Indexes and emerging markets expert. "As they're coming from an often abysmally low base, they have the greatest potential for growth."

Exploring The Economic Frontier

By now, most people "get" emerging markets: They're investable markets, like China or Brazil, whose economies are characterized by an expanding middle class, improving social stability, rising purchasing power per capita and brisk economic growth.

In contrast, frontier markets are countries whose economies are even less developed and accessible than those of emerging markets, but which are still considered investable.

"Generally, frontier markets are smaller, and they've seen rapid GDP growth," said Lourdes Casanova, director of the Emerging Markets Institute at the SC Johnson School of Business at Cornell University. "Their economies tend to be very dynamic."

Often, frontier market economies rely heavily on a single industry or sector: agriculture, for example, or oil production. They may have just opened to foreign investment, like some Gulf nations; or they may already be highly developed with a very small population, like Estonia. Either way, frontier markets are characterized by smaller market capitalizations and lower liquidity than emerging or developed markets.

Frontier markets also tend to exhibit low correlation to other asset classes, even to emerging markets. Over a roughly six-year period, the iShares MSCI Frontier 100 ETF (FM), a good proxy for vanilla frontier market ETF exposure, showed only a 0.54 correlation to common U.S. stocks and emerging markets ETFs. FM's correlations to other asset classes, like commodities, bonds and gold, were even lower (see table below).

Source: PortfolioVisualizer.com; data from Sept. 13, 2012 to July 2, 2018

Big Swings In Single Countries

When frontier markets hit it big, they really hit it big—think Saudi Arabia, for example; or Vietnam, which is often considered the fastest-growing country in the world. In Q1 2018 alone, Vietnam's GDP grew 7.4%.

Nigeria is another good—if under-the-radar—example. Over the past 12 months, the Global X MSCI Nigeria ETF (NGE) rose 19.4%, handily outperforming all other frontier market ETFs (see table below), as well as the U.S. stock market, emerging markets and total world markets (as measured by the SPDR S&P 500 ETF Trust (SPY), the iShares MSCI Emerging Markets ETF (EEM) and the iShares MSCI ACWI ETF (ACWI), respectively).

Sources: ETF.com, FactSet; data as of June 29, 2018

What goes up can also go down, however. In contrast, investors in the Pakistan ETF had a dismal last 12 months, as the Global X MSCI Pakistan ETF (PAK) plummeted 26.1%, compared with a 13.3% rise for SPY, 4.5% for EEM and 9.6% for ACWI.

Performance fluctuations in frontier markets can be brutal in the short term, even if their long-term trend is positive. That makes the asset class most suitable for investors "with a long time horizon who can withstand fluctuations," said Tolle.

"It helps to use a selection strategy in which you have high conviction, because you’ll need to draw on that conviction in tough times," she added. "You need a truly long-term perspective."

Short-term volatility is one reason Steve Cucchiaro, president and chief investment officer of 3Edge Asset Management, prefers indexed instruments for frontier market investing.

"Individual frontier markets can be relatively thinly traded and highly volatile," he said. "For general investors, it's a lot less risky to invest in a basket of several frontier markets."

Currently there are two broad index frontier market ETFs: FM, which has $561 million in assets, and the $66 million Invesco Frontier Markets ETF (FRN). A third ETF, the $19 million WisdomTree Middle East Dividend Fund (GULF), tracks petro states in the Middle East.

Additionally, there are three emerging/frontier market blend ETFs: the $63 million Columbia Beyond BRICs ETF (BBRC), the $16 million Global X Next Emerging & Frontier ETF (EMFM) and the $68 million VanEck Vectors Africa Index (AFK).

These ETFs, plus the five single-country frontier market ETFs, are listed in the table above.

FM & FRN: Not Interchangeable

One might expect FM and FRN to behave very similarly, given that they're both broad market funds in a niche segment. However, these two funds' exposures and track records are very different.

FM is pretty much what you'd expect out of vanilla frontier market exposure. It tracks a market-cap-weighted index of the 100 largest stocks from 20 frontier markets, as classified by MSCI.

FRN, meanwhile, tracks cap-weighted frontier market index depositary receipts and locally domiciled securities. As of 2015, its index uses a slightly different definition of what constitutes a frontier market than it did before. The difference shows up in FRN's track record, which diverges significantly from FM's over the longer term.

Year-to-date, FRN has outperformed FM, though both have notched negative returns. Over a one-year period, however, FM outshines, rising 4.3% versus FRN's 3.6%.

That performance gap widens over longer intervals; on a five-year basis, FM increases 4.1% compared with FRN's 0.3%.  

Less Volatile Than US Stocks

Despite the potential for wide swings in individual countries, frontier markets as a whole appear to be less volatile than not only the broad U.S. stock market, but also emerging markets.

The average beta of the eight pure-play frontier markets ETFs is 0.80, compared with 0.99 for SPY and 1.03 for EEM.

"While each individual constituent can be volatile, a basket of frontier markets actually has lower beta than other stock market indexes," said Cucchiaro.

What's more, volatility also appears to be reduced when blending emerging and frontier market exposure in an ETF, even if there's no clear performance benefit in doing so. The average beta of the three blended EM/frontier funds is 0.60, or 25% less than that of pure-play frontier market ETFs.

Defining Frontier Markets

Because frontier markets are so dynamic, which countries fit the definition constantly changes from year to year, and from indexer to indexer.

"We in the West like to organize the world outside our borders," said Casanova. "But the definition of emerging and frontier market is always a little fuzzy."

In June, MSCI announced it would be reclassifying Saudi Arabia and Argentina, moving them from frontier markets to emerging status starting in 2019. FTSE Russell made a similar announcement earlier in the year.

Reclassifications go both ways, however. Before June's upgrade, MSCI had downgraded Argentina to a frontier market in 2009. It had also dropped Morocco to frontier status in 2013.

As large, more developed economies shift out of frontier market status, it can make the frontier market indexes they leave behind more concentrated and less liquid, at least for a little while.

But the crunch doesn't last forever. New markets develop and grow, until they too are large enough to be considered "frontier."

FTSE has classifications (or stand-alone indexes) for only 78 out of 195 countries in the world, while MSCI has classifications/indexes for 89. That means there are more than 100 countries too small and underdeveloped to qualify as frontier—any number of which could become the next Nigeria or Vietnam.

"It's almost like a professional baseball team's farm system,” said Cucchiaro. “As people get promoted into the minors and majors, it doesn't mean there's any lack of talent in the farm system."

"There's no shortage of markets that can develop and grow," he added. "It's just a question of time as to when they do."