Frontier Markets Lure Intrepid Investors

In the 25 years since World Bank economist Antoine van Agtmael wrote an article for Euromoney magazine titled "Emerging Securities Markets," investors have grown increasingly comfortable with the idea of allocating part of their portfolio to India, Mexico, Thailand, or Turkey. Such is the current popularity of emerging market investing that dozens of emerging market mutual and exchange traded funds are now available to U.S. investors, including bond and equity funds, regional and country funds, sector and style funds, and they have been among the top performers in 2009.

As emerging markets become a mainstream investment option, it's hardly surprising that investors endowed with enough pioneer spirit would start venturing farther afield to "frontier" markets with even smaller, less developed economies. Several frontier markets, particularly those in Asia and Latin America, have turned in blazing performances recently, drawing still more investor interest.

It has not been until recently, however, that professionally-managed funds targeting frontier markets have been readily accessible for individual investors. In 2007, Standard & Poor's and MSCI/BARRA sparked a mini-boom in frontier market ETFs when they began publishing indices composed of companies that were not already represented in their increasingly popular emerging market indices, using stocks from countries such as Botswana, Croatia, Jordan, and Kazakhstan.

Frontier markets are synonymous with risk, says Alec Young, international equity strategist with Standard & Poor's Equity Research. "It's the asset class with the least transparency and information available," he says. While these markets offer the possibility of outsized returns if they are able to achieve and maintain high levels of economic growth as emerging markets such as China and India have done, Young warns that they suffer from sometimes poor disclosure of pertinent information, low liquidity, weak regulation, and high degrees of economic and political risk.

There is no widely accepted definition of exactly what a frontier market is, so funds have some wiggle room when it comes to which companies they will actually invest in. Only two funds specifically bill themselves as "frontier market funds," though others offer significant exposure to both emerging and frontier markets. Three single-country funds from frontier markets have sprung up as well.

Most frontier funds have high sector concentrations that reflect their local economies. They are often heavily weighted to financial, materials, and energy stocks, since those are often the largest companies in the country. While far from perfect, these funds offer one of the only convenient ways to invest in markets still largely untouched by Western capital.

Claymore Frontier Markets (FRN), which tracks the Bank of New York Mellon New Frontier DR Index, is the most geographically diversified frontier ETF. It has 60% of its assets invested in Chile, Poland, and Egypt--all of which are mainstays of emerging markets ETFs. The other 40% is in Colombia, Kazakhstan, Nigeria, and more exotic locations. The fund has been open for business since June, 2008 and has $24 million in assets spread across 39 holdings. Financials account for 35% of the fund, followed by 15% for materials and 13% each for utilities and energy.

PowerShares MENA Frontier Countries Portfolio (PMNA) tracks the Nasdaq OMX Middle East North Africa Index, and has $17 million in assets. It owns 43 companies, mostly in the financial (55%) and telecom (19.5%) sectors. Almost 75% of the fund is invested in the United Arab Emirates, Egypt, Kuwait, and Jordan; it also has exposure to Morocco, Oman, Lebanon, Bahrain, Qatar, and the emirates of Dubai and Abu Dhabi.

Van Eck's Market Vectors Africa (AFK) tracks the Dow Jones Africa Titans 50 index and has $35 million in assets. While its largest holdings are in emerging markets South Africa (28%) and Egypt (19%), it maintains a fairly large exposure to frontier markets like Nigeria (23.7%), Equatorial Guinea (6.4%), and Zambia (3%). Banks and materials comprise about 47% of the fund.

There are now three single-country ETFs for frontier markets, two of which have become instant hits. Market Vectors Vietnam (VNM) tracks the Market Vectors Vietnam index and has collected $79 million in assets since its debut in August 2009. Almost half the fund is invested in the financial sector, with energy and materials another 30% of assets. The MSCI All Peru Capped Index Fund (EPU) has been even more popular, pulling in $93.5 million since it started trading in June 2009. It owns 26 different holdings with two-thirds invested in the basic materials sector. Global X's InterBolsa FTSE Colombia 20 (GXG) has drawn $6 million since it started trading in February 2009. It has 21 holdings, and 50% of the fund invested in banks or financial services.

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S&P Senior Financial Writer Vaughan Scully can be reached at Vaughan_scully@standardandpoors.com. Send him your ideas for ETF story topics.

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