Is 'Frontier' the New 'Emerging'?

Note: This article is part of Morningstar's December 2013 Emerging-Markets Week special report. This article originally appeared Nov. 20, 2013.

The performance of emerging-markets stocks has been very disappointing in 2013, due, in part, to taper talk in the United States and slowing growth among many of the high flyers of the last decade, including China and Brazil. Frontier markets, on the other hand, have had a standout year, with the MSCI Frontier Markets Index returning 21.1% in the first 10 months of the year, trouncing the MSCI Emerging Markets Index's return of 0.3%. Aren't frontier markets just less developed emerging markets? Why has there been such a discrepancy in performance?

Getting in Early
The investment case for frontier markets sounds enticing. These countries, such as Vietnam, Nigeria, and Pakistan, are at an earlier stage of development relative to emerging-markets countries, and some are entering a period of mid- to high-single-digit growth, thanks to favorable demographics, infrastructure spending, and an improving business environment. For example, the managers of Harding Loevner Frontier Emerging Markets (HLMOX) say innovations in financial services in Africa, through mobile and agency banking, will allow for rapid expansion of low-cost banking services and credit, which will likely support more broad-based and inclusive growth. Another positive trend is that a number of resource-rich countries have been able to channel some revenues from the export of raw materials into infrastructure and social spending.

  - source: Morningstar Direct

Although frontier economies are less developed than emerging economies, the MSCI Frontier Index has been less volatile than the MSCI Emerging Markets Index over the past 15 years. Part of this is attributable to the fact that individual frontier countries have low correlations with each other. Another reason is the relatively low level of foreign ownership of frontier-markets stocks. One of the main drivers of volatility in emerging-markets equities during the past few years has been the fact that emerging-markets equities have been considered a "risk on” asset class in the recent "risk-on, risk-off" trading environment. Given the relatively low foreign investor penetration in frontier-markets stocks and bonds, this asset class has not been as susceptible to this hot money-driven volatility.

  - source: MSCI

(The table above under-represents global assets in emerging and frontier markets, as it includes only those assets that are benchmarked to MSCI indexes. However, the data is illustrative of the relative penetration of global assets in emerging markets versus frontier markets.)

Strong frontier-markets performance has not gone unnoticed by investors. While there are only a handful of diversified frontier-markets funds, some have seen organic growth rates (asset growth attributable to net inflows and not market performance) in the eye-popping 200% to 300% range, versus the category (which includes diversified emerging-markets mutual funds and exchange-traded funds) average of 9% over the first 10 months of this year.

Big inflows into this tiny corner of the global equity market have left the biggest fund in the category feeling a bit big for its britches. Templeton Frontier Market Fund , the largest frontier fund, instituted a soft close in June 2013. This fund has only $1.4 billion in total assets under management, so limiting flows at this point indicates the capacity and liquidity constraints of the asset class. The second largest fund, at $800 million in assets, is Wasatch Frontier Emerging Small Countries (WAFMX), which launched in January 2012. While this fund is still open, Wasatch has stated "this fund is expected to have limited capacity due to its specialized nature." The third-largest fund in this space, at $350 million in total assets, is iShares MSCI Frontier 100 (FM), an ETF that started trading in September 2012.

Understanding the Risks
The MSCI Frontier Market Index covers about 85% of the free-float-adjusted market capitalization of 25 frontier stock markets. The index has a total of 142 constituents, whose combined free-float-adjusted market capitalization is around $130 billion, equivalent in size to the market capitalization of individual companies such as  PepsiCo (PEP) or  Merck (MRK). By way of comparison, the free-float-adjusted market capitalization of the MSCI Emerging Markets Index is $3.9 trillion. With such limited capacity, strong inflows into frontier-markets stocks will likely drive markets higher. However, any sudden pull-back by foreign investors could result in brutal declines. Emerging Southeast Asian markets, which boast far more liquidity than frontier markets, were recently victims of this phenomenon. For example, iShares MSCI Philippines (EPHE) and  iShares MSCI Thailand (THD) enjoyed an 80% and 60% climb, respectively, from January 2012 through mid-May this year, due in part to surging inflows into both local equities and bonds, which drove up both equity prices and currencies. The rally hit a wall when the Federal Reserve Chairman Ben Bernanke first hinted at an eventual tapering of the Fed’s asset purchases, and in the following three months, these funds each fell 30%. If investors continue to pile into frontier markets, they too will become part of the risk-on, risk-off trade, and will likely grow more correlated with U.S. markets.

Most investors are familiar with the main risks associated with frontier markets, which include political instability, social unrest, widespread corruption, and a fickle regulatory environment. For example, during the Egyptian Revolution of 2011, the local stock market shut down for 40 consecutive days, and Market Vectors Egypt , which primarily invests in Egyptian securities, fell 50% that year. Argentina, another former high flyer, is now an economic basket case. MSCI downgraded Argentina from the Emerging Markets Index to the Frontier Markets Index in 2009 as a result of restrictions on the flow of capital into and out of the country. Currently, MSCI is considering excluding Argentina from the Frontier Market Index after the nationalization of YPF in 2012, a company that was 51% owned by Spanish oil firm Repsol SA (REPYY).

What Are the Investment Options?
After acknowledging the many risks to frontier markets, investors should also carefully weigh the pro and cons of the different funds offering exposure to this very niche asset class.

Passively managed iShares MSCI Frontier is by far the cheapest option for geographically diversified frontier-markets exposure. This ETF has an annual expense ratio of 0.79%. Since inception in September 2012, this fund has trailed its index by 40 basis points, which is less than its annual expense ratio, indicating the fund is doing a good job tracking its index. However, a bigger challenge looms for the managers of this fund, in the form of a large index change, which was announced by MSCI last June. Later this month, Morocco will be downgraded from the MSCI Emerging Markets Index (where it currently accounts for 0.01% of the index) to the Frontier Markets Index (where it will account for about 4%), and in May 2014, Qatar and UAE will be upgraded from the Frontier Market Index (where together they account for 30%) to the Emerging Markets Index (where together they will account for around 1%).

Index-tracking funds that invest in relatively illiquid securities face two key challenges--front running and market impact costs. These issues affect both the fund and the index, making it difficult to measure their effect. Morocco’s Casablanca Stock Exchange expects the market downgrade will result in additional fund flows--Morocco currently accounts for 0.01% in the MSCI Emerging Markets Index but will account for about 4% of the MSCI Frontier Index after the November change. So while emerging-markets fund managers may have ignored Morocco because it represented a small sliver of their benchmark, frontier-markets fund managers will likely consider Moroccan stocks given their more significant weighting in the frontier benchmark. Moroccan stocks have enjoyed somewhat of a rally during the past few months, which the iShares MSCI Frontier fund will have missed when it adds Moroccan securities on Nov. 27. The fund may also further fuel the rally on and around the index change date, given the size of the fund and the relatively low liquidity of Moroccan stocks. Following this and the May index changes, FM’s portfolio will be more concentrated, as Kuwaiti stocks (which will account for about 30% of the fund’s portfolio) and Nigerian stocks (20%) will account for roughly half of its assets.

As Morocco may benefit from a downgrade to frontier status, Qatar and UAE may benefit from an upgrade to emerging-markets status. Often, a country is upgraded in recognition of significant economic reforms, which are often a precursor to an improved growth outlook. Reclassification also raises the profile of a country’s stock market within the foreign investment community and could drive significant capital inflows. Egypt was a glowing success story for a few years after it was added to the MSCI Emerging Markets Index in June 2001. Thanks to tariff cuts, economic liberalization, and privatization, Egypt enjoyed strong increases in foreign direct investment and portfolio inflows, and from 2003 to 2007, the MSCI Egypt Index returned an average of 84% a year. A strict, frontier-markets index fund such as FM would have missed out on this type of market performance. (That said, the Egypt story has definitely taken a more negative turn in more recent years, and MSCI is currently looking to remove Egypt from the Emerging Markets Index as it has become more difficult for foreign investors to repatriate their capital. This is yet another example of the many risks of this asset class.)

Because countries at the border between frontier and emerging markets may benefit from increasing investor interest, as well as improving fundamentals, a better option may be a fund like EGShares Beyond BRICs . This fund, by investing in smaller emerging markets (75%) and frontier markets (25%), will most likely include these borderline countries and see less turnover as it won’t have as many country upgrades and downgrades. This will also help reduce transaction and market-impact costs, relative to an index fund like iShares MSCI Frontier. However, while BBRC is more geographically diverse, a number of smaller countries are represented by only one security. This fund is also still quite small, very thinly traded, and only recently added frontier-markets stocks when it changed its benchmark index in October 2013. Given its small size, there is a risk that this fund could ultimately close. And in light of its sparse liquidity it is important to use limit orders to ensure good execution for smaller trades. Those looking to transact in an amount greater than 10% of the fund's average daily trading volume should engage the help of a market maker in order to reduce the cost of executing a trade in this fund.

An actively managed fund is probably the best option for frontier-markets exposure. Frontier stocks, like micro-cap stocks, are relatively illiquid and are not well covered by investment analysts. Specialist active managers with focused analyst staff may be better positioned to exploit these inefficiencies. At this time, there are no frontier-markets equity funds with a Morningstar Analyst Rating, but there are two worth mentioning, although they are expensive. One option, Harding Loevner Frontier Emerging Markets, shares two of its three portfolio managers with the Silver-rated  Harding Loevner Emerging Markets (HLEMX). This frontier fund’s five-year Sortino Ratio of 1.17 was ahead of the MSCI Frontier Market Index’s 0.36, but more recently, the fund has underperformed the MSCI benchmark. This fund charges an annual fee of 1.95%. Another option is Wasatch Frontier Emerging Small Countries Fund. This fund is off to a strong start (both in asset flows and performance), but is somewhat pricy with an expense ratio of 2.25%. It is managed by Laura Geritz, who is the comanager on the successful  Wasatch Emerging Markets Small Cap (WAEMX). 

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