Frontier Markets Haven't Been Immune

Frontier markets were enjoying their moment in 2014. Relatively risk-tolerant investors were beginning to notice this very tiny area of the market, thanks to the strong outperformance of frontier-markets funds, relative to emerging-markets funds, over the prior two years. By the end of 2014, there were 15 broad frontier-markets funds, nine of which were launched in 2012 or after.

But 2015 has been a rough year for this group of funds. For the year to date, the five largest broad frontier-markets funds have been underperforming the MSCI Emerging Markets Index by an average of 400 basis points. Historically, individual frontier-markets countries have high idiosyncratic risks, but when investments from these countries are combined into a geographically diversified portfolio, this can result in some risk mitigation. (This is relative to a diversified emerging-markets fund, where individual emerging-markets countries have been growing more correlated over the past few years.) However, many of the large frontier markets, such as Nigeria, Kenya, Kuwait, and Argentina, all saw their respective stock markets, and currencies, exhibit sharp declines in 2015. There are a number of reasons for these declines, including weak global demand for these countries’ exports, political instability, and terrorism. These issues have weighed on these countries’ public finances, stock markets, and currencies. Frontier markets are defined by their underdeveloped institutions, inchoate financial systems, weak rule of law, and fairly illiquid capital markets. So in other words, no matter what anyone says, frontier-markets investing continues to be very risky.

Below is our report on

Suitability IShares MSCI Frontier 100 is an index fund that provides exposure to frontier-markets stocks. The fund invests in about 20 frontier-markets countries, but as a result of its market-cap-weighting methodology, the two largest country allocations account for approximately 40% of the fund. Given the volatility of individual frontier-markets countries and currencies, investors are usually better served holding frontier-markets funds that are more geographically diversified. This fund's country concentrations are a source of risk.

Frontier markets, by definition, are at the far edge of the investment universe and are generally not included in global equity indexes or even in many emerging-markets equity funds. This is because frontier capital markets are not easily accessible. These markets tend to have a small number of liquid securities and restrictions on foreign ownership.

MSCI distinguishes frontier markets from emerging markets by capital market size, liquidity, and accessibility thresholds on foreign ownership. In other words, investability is the primary criteria for a country’s classification, with aggregate and per capita gross domestic product figures playing more of a secondary role. This fund primarily contains stocks listed in the Middle East, Africa, former Soviet Republics, and less-developed Asian countries such as Pakistan and Vietnam. While frontier markets in African and Asian countries tend to have very low per capita GDP figures, the oil-producing states in the Middle East are relatively wealthy. These resource-rich nations are considered frontier markets because their exchange-listed companies have restrictive foreign ownership limits.

This fund tracks a market-cap-weighted index, which means that the countries with the largest capital markets have the largest weightings. Using capital market size to determine country allocations within a frontier-markets portfolio is somewhat arbitrary, especially in an asset class composed of underdeveloped economies, where the equity market capitalization/GDP ratio is very inconsistent across the investment universe. This fund’s largest country weightings are Kuwait (26%), Nigeria (14%), Argentina (13%), and Pakistan (11%), which together account for more than 60% of the fund. Again, given the volatility of individual countries and currencies, investors may want to consider frontier funds with less country concentration.

Fundamental View The investment case for frontier markets sounds enticing. Countries such as Kuwait, Nigeria, and Pakistan are at an earlier stage of development relative to emerging-markets economies. Many frontier-markets economies are entering a period of mid- to high-single-digit growth, thanks to a very low economic base, favorable demographics, growth in infrastructure spending, and, in some cases, abundant natural resources. And relative to emerging markets, certain frontier countries will benefit from the rapid adoption and dissemination of new economy services such as mobile banking and mobile payments, which should contribute to growth in the medium term.

But certainly, frontier markets are risky because of political instability, social unrest, corruption, disease, terrorism, underdeveloped financial systems and capital markets, and a fickle regulatory environment. During periods of extreme market stress, frontier markets' relatively illiquid stock markets can suffer sharp declines in the face of heavy selling. Recent declines in commodity prices have prompted selling pressure in frontier markets, as many countries in South America, the Middle East, and Africa are commodity exporters. Many of these countries have also recently experienced sharp declines in the value of their currencies.

When looking at other measures of risk, frontier markets tend to fare a little better. Partly because of lower levels of integration with the global economy, each frontier market tends to have more idiosyncratic risks, historically exhibiting low correlations with one another. As a result, frontier-markets funds have been less volatile (as measured by the rolling three- and five-year annualized standard deviation of returns) than the MSCI Emerging Markets Index.

Index funds in relatively illiquid asset classes face unique challenges relative to their actively managed peers. For example, index changes are typically announced to the market weeks or months beforehand. As such, a frontier-markets index fund may face front-running and/or large market-impact costs when executing an index change. Actively managed frontier-markets funds also define their investment universe more broadly and tend to include smaller emerging-markets countries, such as the Philippines and Peru. Drawing from a larger investment universe may help mitigate liquidity issues and improve diversification within a fund. In addition, some of these countries sit at the border between frontier and emerging markets and may benefit from increasing investor interest as well as improving fundamentals. For such a small asset class as frontier markets, this exchange-traded fund, with its more narrowly defined investment universe (MSCI Frontier Markets 100 Index), may be at a disadvantage relative to its actively managed peers.

Frontier market funds are relatively new and untested. There are 16 frontier-markets mutual funds and ETFs that invest broadly across frontier markets (and, in many cases, smaller emerging markets). The first five launched in 2008 and were still very small funds during the global financial crisis. Investor interest in frontier markets is growing. As more foreign funds flow into frontier markets, these relatively illiquid markets could face stress during large outflows.

Portfolio Construction This ETF tracks the float-adjusted, market-cap-weighted MSCI Frontier Markets 100 Index, which is a subset of the MSCI Frontier Markets Investable Market Index. Constituents of the MSCI Frontier 100 Index have to meet minimum liquidity thresholds and have sufficient foreign room (the proportion of shares still available to foreign investors relative to the maximum allowed). The MSCI Frontier 100 Index is part of a suite of MSCI's tradable indexes that was created for less-liquid asset classes such as frontier markets. The composition of the index is reviewed in May and November. At the semiannual rebalance, the index can include between 85 and 115 securities. There is a 40% cap on the aggregated weighting of the two largest country allocations. The index does not hedge its foreign-currency exposure. In 2014, MSCI upgraded United Arab Emirates and Qatar from its Frontier Markets Index to its Emerging Markets Index. Prior to this index change, UAE and Qatar accounted for about 40% of this fund. To implement the change, the fund tracked a transition index, which allowed it to implement this change gradually over a six-month period. This was done to mitigate potential execution challenges, as frontier countries tend to have shallow capital markets, which can result in higher execution costs.

Fees This ETF charges an annual expense ratio of 0.79%. In the 12 months ended Sept. 30, 2015, the fund's net asset value performance trailed its index by 88 basis points, which is close to the fund's expense ratio. This suggests that iShares has been able to efficiently track its index.

Alternatives

Frontier stocks, like micro-cap stocks, are relatively illiquid and are not well covered by investment analysts. Specialist active managers with a focused analyst staff may be better positioned to exploit these inefficiencies.

Another option is unrated Matthews Emerging Asia MEASX, which invests in emerging Asia (60% of the portfolio) and frontier Asia (40%). The retail share class charges 1.48%. Taizo Ishida has been the lead manager since the fund's inception in 2013, and he also manages Silver-rated

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