Last June, MSCI announced that it would be reclassifying Qatar and the United Arab Emirates as emerging rather than frontier markets starting this year, and in May that reclassification will tilt the composition of both frontier and emerging market indexes and funds in ways that demand attention.
That will be followed in September by a similar reclassification of the two countries from frontier to emerging markets by S&P Dow Jones Indices, which announced its intent last September.
Frontier markets are, of course, considered the riskiest among world markets in which to invest, since some of the countries included in that category may not even have functioning stock markets. Sectors usually found in frontier markets include those that bring in regular monthly payments from customers – such as telecommunications, financial and consumer-oriented companies – and are often less liquid, provide less transparency than offerings in more developed markets and carrier higher investment fees as well.
Currencies in frontier markets may fluctuate more often and to a greater degree than in more developed markets. In addition, frontier markets are often located in countries that are less politically stable, providing other risks – anything from revolution to nationalization.
Emerging markets are farther down the road toward development, providing more political and economic stability, additional transparency, better liquidity and more developed stock markets. However, they still offer greater risk than developed markets, if perhaps in different areas. In addition, their rate of growth may not be as swift as in frontier markets, which may have greater potential as markets advance and businesses grow – hence their allure.
While funds concentrating on frontier markets have been able to provide healthy returns over the last several months – MSCI’s FM (Frontier Market) Index, for example, has seen a 19.5% increase over the 12 months ending March 28, compared with MSCI’s EM (Emerging Market) Index, which is down 4.62% over the same period – that could change once Qatar and the UAE shift positions.
There are three reasons for that, according to Amrita Bagaria, ETF product manager at Van Eck Global.
First, said Bagaria, “For folks who are holding an ETF that tracks a frontier market index like MSCI, they won’t get exposure to those two countries any more. They’re the second and third largest in the index, so [they make up] almost 40% of the index. It’s a big deal.”
Second is the fact that once those two countries are classified with emerging market nations, “they will have a much smaller effect” on any index or fund in which they’re included. Bagaria pointed out that Qatar and the UAE “will be competing with China, India and Russia, so they’ll be present in a significantly smaller allocation. If you wanted exposure [specifically to those two countries], it would be quite diluted by BRICS and other emerging markets that are much larger.”
Third is the fact that, among the nations of the gulf, which also include Bahrain, Kuwait, Oman and Saudi Arabia, Kuwait, Qatar and the UAE are the ones that have had the largest return on investment. Once the latter two are recategorized, it’s likely that the returns of the remaining frontier market countries will be lower.
Bagaria said, “These two countries over the last couple of years have performed extraordinarily well. So we think you should stick with them even though they won¹t be included in frontier markets anymore.”
Van Eck Global’s Market Vectors Gulf States ETF (MES) is one way to do that. MES offers pure-play exposure to companies domiciled in the countries that make up the Gulf Cooperation Council region, which includes Bahrain, Kuwait, Oman, Qatar, Saudi Arabia and the UAE.
According to Van Eck, MES has brought in returns of 38.07% during the 12 months ended March 28, and provides investors with exposure to the sectors that have driven much of the growth in the council’s region: financial, industrial and telecommunications. With more than 85% of MES’ holdings made up of Kuwaiti, Qatari and UAE companies, as long as those countries continue to experience growth, so should returns.
Money has been flowing to investments in the two countries, with actively managed funds boosting holdings, and that appears unlikely to change in the near future. Another fund offering exposure to the two that will not be affected by their change in status is WisdomTree’s Middle East Dividend Fund (GULF).
In addition, investors holding iShares’ MSCI Frontier 100 ETF (FM) might decide to investigate instead its MSCI Emerging Markets ETF (EEM), since Qatar and the UAE will be relocated there.
Whatever investors decide to do, Bagaria said that the UAE and Qatar, as the two largest countries in MES, with the former making up 38.8% as of the end of February and the latter 25.2%, “we’ve obviously been very, very pleased with their performance.”
That’s one thing not likely to change in the near future.