Investing Frontiers Beyond BRICs

By Seth Van Brocklin

  • One or more of these little-known frontier markets could become the next big thing in the years ahead.
  • Inside: The good, the bad, and the ugly of frontier market funds.

A frontiersman seeks new opportunities in areas where few others dare venture. He is willing to assume greater risk in exchange for the greater potential reward. Playing it safe isn’t his style.

For investors with a similar sense of adventure, there are frontier markets.

Frontier markets refer to stock markets in under-developed, rough-and-tumble parts of the world. Places like Africa, South Asia, and parts of Latin America. These are countries that aren’t yet even emerging markets. They could more aptly be called pre-emerging markets.

We covered emerging markets in the January issue. And we spotlighted the BRICs countries (Brazil, Russia, India, and China).

Emerging markets remain an attractive area for long-term investment. Despite recent political, geopolitical, and economic troubles in the emerging world, emerging markets have good growth prospects. These countries now account for 40% of the world’s gross economic output, says the International Monetary Fund.

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Frontier markets represent a much smaller share of the world economy and just a tiny share of world stock market capitalization. The total market capitalization of the MSCI Frontier Markets

Index is estimated at just $110 billion, compared to $4 trillion for the MSCI Emerging Markets Index. Therein lies the value opportunity. Over time, frontier markets can be expected to gain on emerging markets, just as emerging markets can be expected to gain on developed markets. To be sure, there are downsides to venturing into frontier countries. Their capital markets are thin. Their governments can be unstable. Risk is high if you invest in just a single frontier country.

But if you spread your investment across multiple frontier markets, you gain the upside of being out on investing frontiers without the risks of being a frontiersman on the high plains. In fact, investing in a diversified basket of frontier markets is less risky than investing in other types of markets. As Morningstar concluded, “Individual frontier-markets countries tend to have high idiosyncratic risks, but diversified frontier-markets funds (comprising companies’ from 10 or more countries) tend to be less volatile than emerging-markets funds.”

Frontier investments can actually reduce risk when used to diversify a broader portfolio that would otherwise be concentrated in other areas. A 2013 study published in the Journal of Portfolio Management found that a modest allocation to a frontier markets fund improves the risk-adjusted performance of a stock portfolio that is concentrated in developed and emerging markets.

Most developed markets and, increasingly, emerging markets, show a strong positive correlation with one another. Frontier markets, by contrast, are less correlated with global equities. A frontier market can move up when the rest of the world is moving down.

Downside Risks vs. Upside Potential

The economies of frontier countries are experiencing rapid rates of growth. In fact, they are outpacing not only the developed world, but also emerging markets. Future growth prospects are bright because frontier countries tend to have young demographic profiles. The Third World will grow even if it remains poor on a per capita basis. At the same time, Western and East Asian economies will stagnate (at best) as their populations age and ultimately shrink.

China was once a frontier economy with primitive infrastructure and little industry. It’s now the world’s second largest economy (and will soon overtake the United States for first place). When I walked the streets of Shanghai last year, I couldn’t help but feel like I was in more of a First World city than some U.S. cities that have much higher crime rates and crumbling infrastructure. Of course, conditions in some parts of China are more primitive.

But there are many parts of the world today that seem primitive and not worth investing in that will be future boom towns. Vietnam? Mongolia? Kazakhstan? Kenya? These are frontier countries that have tremendous growth potential even though few investors today pay any attention to them. Just as few investors paid any attention to China in the 1980s when it was a backward, inaccessible frontier market.

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Global investors back then thought Japan was the only game in town. Its stock market became way overvalued. It crashed and still hasn’t recovered back to its highs of a quarter century ago.

Many investors now think the U.S. is the only game in town. Its market has become overvalued compared to most foreign markets. The most undervalued foreign markets of all may be frontier markets.

There are a dozen or so funds currently open to new investors that track frontier markets. Or at least they purport to do so. Unfortunately, most of them have serious deficiencies. Some of these “frontier market” instruments feature portfolio construction that makes them difficult to classify. Just because a fund contains “frontier” in its name doesn’t mean its holdings reflect a sensible representation of actual frontier countries.

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The Guggenheim Frontier Markets ETF (FRN) allocates a whopping 40.9% of its assets to a single country (Chile) that isn’t even widely considered to be a frontier market. Its next two biggest country weightings are Argentina (15.9%) and Columbia (13.6%). Essentially, you’re getting a poorly balanced Latin America fund with a sprinkling of diversification from other parts of the world.

FRN contains only 39 securities. That is insufficient for a diversified multi-country portfolio.

The iShares MSCI Frontier 100 ETF (FM) scores better on portfolio construction. It has 100 holdings and less regional concentration at the top. FM designates Kuwait for its top country allocation (25.1% of assets).

Kuwait doesn’t match most people’s idea of a frontier market. Thanks to its oil resources, the country enjoys very high standards of living. But its stock market is infantile and largely untapped by global investors. That leads many to classify Kuwait as a frontier market.

The iShares Frontier 100 also includes allocations to African, Asian, South American, and Eastern European frontier markets. Of all the instruments dedicated to frontier markets, FM appears to come closest to being a truly representative frontier markets index fund.

Actively Managed Funds Can Be More Nimble – But at Greater Cost

Frontier markets are a niche area in which a skilled fund manager could conceivably add value versus passive indexing. Index funds have proven to deliver superior after-fee returns in highly liquid, widely followed markets such as the United States. The more efficient the market, the less opportunity there is for asset allocators to gain an advantage and beat the market.

But in more obscure markets, a good asset manager could potentially steer clear of dangers and exploit hidden opportunities in a way that index funds cannot.

If you prefer active management, Harding Loevner Frontier Emerging Markets (HLFMX) is run by a capable team of managers. They have a track record of producing good risk-adjusted returns in foreign markets. As its name suggests, the fund includes both frontier and emerging markets equities. HLFMX currently allocates about 70% to frontier markets.

The question for investors is whether the 1.75% expense ratio (versus 0.79% for the iShares FM ETF) is worth it. Study after study has shown that the longer the holding period, the less likely it is that a fund with a relatively high expense ratio will perform better than a similar fund with a significantly lower expense ratio.

Hybrid Emerging/Frontier Markets Funds

Combining a focus on frontier markets with an allocation to emerging markets, as HLFMX does, might seem prudent for purposes of diversification. But there are lower-cost ETFs that do this as well. Global X Next Emerging & Frontier ETF (EMFM) allocates 77% to emerging markets and just 23% to frontier markets. EGShares Beyond BRICs (BBRC) offers a similar 75% emerging/25% frontier markets breakdown, while excluding BRICs countries. Both instruments sport expense ratios of 0.58%.

While 0.58% is reasonably low, it’s still a lot higher than the miniscule 0.15% levied by Vanguard Emerging Markets (VWO). This highlights the importance of pursuing low-cost strategies to achieve your investing objective. Sometimes it’s more cost-effective to hold multiple instruments in order to execute an investing strategy rather than a single one.

For investors who seek a roughly 75% allocation to emerging markets and 25% to frontier markets, it’s cheaper to invest 75% in VWO and 25% in a frontier fund rather than 100% in a single hybrid emerging/frontier fund with a higher expense ratio.

At the same time, beware of funds whose focus is too narrow or specialized. For example, the WisdomTree Emerging Markets ex-State-Owned Enterprises (XSOE) exchange-traded fund targets investors who seek to reduce risk. But it may expose them to greater risk (and cost).

The strategy of excluding state-owned enterprises seems sensible. Especially given the corruption scandals emanating from places like Brazil (with Petrobras) and the general inefficiency of governmentowned businesses. But XSOE’s expense ratio (0.58%) is nearly 4 times higher than VWO’s.

And it is so thinly traded, with only $10 million in assets, that investors face huge bid/ask spreads. Along with the risk that the instrument will eventually be delisted due to insufficient demand. With $63.4 billion in assets, Vanguard Emerging Markets carries no such liquidity risks.

Frontier markets funds will necessarily be smaller and less liquid. But with $575 million in assets, iShares Frontier 100 (FM) is sufficiently capitalized. It looks like it’s here to stay – as is the viability of frontier markets investing.

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