Borat Can Laugh, but Offbeat Markets Are No Joke to Funds

Perhaps the turning point came in August 2006, when  Vanguard Emerging Markets Stock Index (VEIEX)changed its guidelines. 

Up to that point, the fund had excluded some of the countries featured in MSCI's standard emerging-markets index because of trading complications or other factors. Over the years, Vanguard had allowed in country after country as their conditions improved, but a few--including Russia, which had become more and more prominent in actively managed portfolios--were still left out. Then in August, Vanguard tossed out its custom index and simply adopted the MSCI Emerging Markets Index as its benchmark. Immediately Russia became the third-largest stake, with more than 10% of assets.

Russia thus joins the many other countries that once languished far off of the radar screen for nearly all fund managers, but which now show up in portfolio after portfolio. So, with such holdings becoming commonplace, what's a manager looking for an edge to do? For some, the answer has been to turn toward even less-familiar destinations. These areas, often called "frontier" or "pre-emerging" markets, are becoming more noticeable among emerging-markets funds and among some broader funds as well.

How should you respond to this trend? In general, avoid becoming either too alarmed or too excited. In other words, don't panic if you see a Moroccan bank suddenly show up in the portfolio of your supposedly mainstream fund, but don't immediately start plotting how to cash in on this trend, either.

The Emerging-Markets Hierarchy
Rather than lumping all emerging markets together, many professional international investors divide those countries into different tiers. They make these distinctions based loosely on considerations such as the levels of liquidity and regulation in the stock market and/or economy, the strength of the legal system, and the amount of political risk. At the top stand South Korea, Taiwan, and Israel, which are close to being considered developed markets and in fact are already classified as such by some services, and perhaps a few others, such as Brazil and Mexico. Then there's a broad middle ground--which itself could easily be divided into two subgroups--which would include India, Poland, and Turkey, among many others.

Finally, some countries have such young or rudimentary stock markets or have such high levels of political risk that they fall into the frontier or pre-emerging category. A few examples are Vietnam, Kazakhstan, Morocco, and markets in the Persian Gulf.

It's worth noting that the above divisions aren't intended to be formal or definitive. The details are certainly debatable; some people might assign certain markets to a different tier or propose dividing the group into more (or fewer) categories. The basic concept is what's key.

Surveying the Landscape
The current crop of frontier managers are by no means the first to discover these areas. After all, large corporations have been investing in obscure corners of the globe for centuries. Jim Rogers, former successful hedge-fund investor turned globetrotting "investment biker," began touting extremely out-of-the-way locations as excellent investment opportunities decades ago. And some emerging-markets managers were investing in places such as Russia when those were off-limits for most. But for conventional U.S. mutual funds--as opposed to hedge funds or private capital--only recently have investments in Sri Lanka or Dubai or Kazakhstan begun showing up in portfolios with any frequency.

One fund actively taking this path is  DWS Emerging Markets Equity (SEMGX), whose manager has nearly 1% of assets in a Dubai property developer and a similar amount in a Moroccan conglomerate, not to mention a Kazakhstan gas play. He's also interested in companies in Kuwait and in several sub-Saharan African markets, including Kenya and Zambia.  Templeton Developing Markets (TEDMX) bought that same Dubai firm recently; in fact, that's where lead manager Mark Mobius was located when we recently spoke with him about his portfolio. Meanwhile,  Lazard Emerging Markets' (LZEMX) manager talked with us last month from Vietnam, where he was scouting for opportunities. That small stock market enjoyed a spectacular rally in 2006; Eaton Vance Structured Emerging Markets (EAEMX) already has a Vietnamese holding in its top 10.  T. Rowe Price Emerging Markets Stock (PRMSX) owns a bank in Oman.

This exploration isn't limited to dedicated emerging-markets funds. Lord Abbett International Core Equity (LICAX) has 1.5% of assets invested in a bank in Kazakhstan through a private placement.  Julius Baer International Equity (BJBIX) has put money into Romania in recent years. It's debatable whether one can call this a frontier market, given that the country joined the European Union this year, but you don't see a whole lot of managers of broad international funds tossing money Bucharest's way, either. The Julius Baer fund has a combined 3% of assets invested in Romania, Serbia, and Ukraine, mostly in the banking sector.

Interestingly, emerging-markets-bond managers have long ventured into frontier markets. They've had little choice, for they have to go where the high-yielding debt is, and countries in the top tier of emerging markets don't issue much of it. Lately this trend has taken a particularly bold turn: Several emerging-markets-bond managers have delved into Iraqi bonds.

Should You Be Afraid?
In general, you shouldn't be concerned if you see frontier markets showing up in your fund's portfolio. For one thing, they almost always appear in very small amounts. More importantly, these markets do offer opportunities. After all, while Kazakhstan might be best known to many Americans as the much-maligned homeland of a fictional film character, in the real world it's a country to be reckoned with, boasting substantial energy resources. Dubai is experiencing an incredible construction boom as the government is undertaking a monumental effort to build it up as a regional financial and tourism center.

Given that a mutual fund investing in India or Poland might have seemed a radical idea not too long ago, it's important to recognize that what now seems hopelessly exotic can easily become commonplace. More to the point, if you want your fund to beat the index and outpace rival funds--and it must in order to earn its fees--then you have to allow its manager some freedom to deviate from the index and peers and accept the risks that come with that.

However, there's no question that those risks are real. Just because I accept and even welcome managers going beyond the geographic norm doesn't mean I think this approach works in all cases. And the fact that such markets are becoming more popular certainly doesn't mean you should seek out funds with the highest weightings in Oman or look for ways to pour money into a Kenyan private-equity play. To highlight the dangers, it's sufficient to point out that several newly popular Persian Gulf markets lost more than half their value in 2006. Political risks are greater in these countries, and trading volumes are lighter, meaning that a relatively small amount of investors pulling out can quickly create a powerful downdraft.

And remember that any emerging-markets fund, whether it owns stocks in frontier markets or not, stands on the more-aggressive end of the investment spectrum. Keep any allocation to these regions relatively small, and, given the likelihood that you'll encounter substantial volatility along the way, make sure you truly intend to ride out the rough spots and hold on for a very long time.