S&P's Extended Frontier Index Makes Emerging Markets Look Developed

Ah, yes, the Unknown West. The Wild East? Russia? India? Wait – Pakistan, really? Bahrain and Kuwait? Colombia and Jordan?

In August, Standard & Poor's launched its S&P/IFCG Extended Frontier 150 Index, offering a glimpse of what future investment opportunities would look like for globalists hoping to diversify beyond the current suite of emerging market flavors. Now, with a new Select Frontier Index, anticipation among investors about finally being able to peel away layers of the emerging markets onion has increased about as much as the YTD performance of iShares' FTSE Xinhua China Index (FXI).

According to S&P, the Extended Frontier 150:

Consists of the 150 and most liquid companies from over 30 countries…and uses a modified market capitalization scheme to ensure that no country has a weight greater than 15% in the index and no security is over 10% of the index.

But the S&P Select Frontier Index is a subset of that index:

The S&P Select Frontier Index consists of 30 of the largest and most liquid companies from markets excluded from the S&P/IFCI Emerging Markets Index…At each rebalancing, to be eligible for the Index, a stock must have a minimum float-adjusted market capitalization of US $100 million, a minimum average daily value traded of US $2 million, and a minimum of 15 days traded over each of the previous six months.

Specifically, S&P lists the following countries as eligible through local markets for investment representation in the index:

Bahrain, Bulgaria, Colombia, Croatia, Jordan, Oman, Pakistan, Romania, Sri Lanka, UAE, and Vietnam.

Through ADRs, GDRs, or H Shares, the following Frontier Markets are available for representation, and components from these markets could be added in the future:

Bangladesh, Cambodia, Cote d'Ivoire, Cyprus, Ecuador, Estonia, Georgia, Ghana, Jamaica, Kazakhstan, Kenya, Kuwait, Lebanon, Lithuania, Mauritius, Namibia, Nigeria, Panama, Qatar, Slovenia, Sri Lanka, Trinidad & Tobago, Tunisia, Ukraine, and Zimbabwe.

According to Heather Bell at Index Universe, the current Index is comprised of the following countries, along with their weightings:

• Pakistan – 28.97%
• UAE – 23.12
• Jordan – 13.23
• Vietnam – 11.54
• Panama – 7.74
• Kazakhstan – 7.10
• Colombia – 6.24
• Bulgaria – 1.05
• Cambodia – 1.01

More specifically, Pakistan is not only the most heavily weighted nation, but also harbors the heaviest (single-) weighted company, MCB Bank Limited, at 10.23% of the index's holding. According to Ms. Bell, rounding out the top five holdings include:

• UAE – Emaar Properties – 9.40%
• Panama – Copa Holdings SA – 7.74%
• Jordan – Arab Bank – 7.62%
• UAE – Aldar Properties – 6.24%

For those of us waiting for the opportunity to invest in Vietnam through possible ETFs, the country's Sacombank will avail us of some representation, if only at 4.20%.

A little math reveals an interesting breakdown of index representation:

• Asia – 12.55%
• Europe – 1.05%
• Middle East – 72.42%
• South America – 13.98%

Although brokerages including Goldman, Lehman, and Merrill offer slightly divergent opinions as to what constitutes the "frontier markets", consensus reveals that we're talking about roughly one billion people, and about $2.4 trillion of global capital. The fact that this capital isn't the world's most liquid not only makes these markets somewhat more difficult to value but makes their reactions to political and socioeconomic events murky.

Also, in a recent article, I suggested that low correlation plays – low "R^2" vehicles – among ETFs have moderately to soundly outperformed the S&P since the August swoon. Shouldn't these frontier markets, with heavy commodities and startup industrial exposure (refining, basic materials processing, etc.) provide low correlation to the S&P? They do. In Merrill Lynch's universe, the frontier markets sport a 0.31 R^2 value as compared to the S&P. Ms. Bell's work reveals a far lower correlation – just 0.175 between the S&P Broad Market Index and the Select Frontier Index. This would land an hypothetical Frontier Index ETF among the XLE and various natural resources ETFs in terms of R^2 values.

But low correlation can sometimes mean returns that underperform the S&P. In fact, for the three months ended September 30th, the S&P 500 earned 2.03%, while the Frontier Index was down 5.61%. Finally, a bit more math suggests that what S&P asserts is true: the correlation between frontier and developing markets has remained below 0.50 for the past several years (while the correlation between emerging and developed markets frequently pushes north of 0.80).

With ETF investors continuously looking for new areas for growth and – dare I say it – experimentation, it is likely that this sub index, based on liquidity and market capitalization, will likely form the basis of a new generation of ETFs. In the next year, many hope to see index products tracking various nations represented by the Frontier Index. Until then, I'll be monitoring this frontier land, debating how much of my chili and gunpowder to trade for a guide to take my trusty Conestoga further into the unknown frontier…

Invest soundly.

Comments

[User 86999]

Why does it sound like ranting? Need focused writing and if there are any particular etfs, provide their tickers when you talk about them.