Claymore Launches First Ever Frontier ETF; PowerShares, Van Eck Close Behind

By Heather Bell

Until Thursday, frontier markets were probably the hottest investments that investors couldn't get at. Ever-hungry for diversification as developed markets begin to correlate more closely with each other, investors began to cast covetous eyes upon some of the world's smallest markets some time ago, but there were very few ways to access them easily.

Now Claymore Securities has burst onto the scene with the first U.S.-listed exchange-traded fund to cover frontier markets. The Claymore/BNY Mellon Frontier Markets ETF (FRN) tracks an index from Bank of New York that currently includes 42 ADRs from 15 different countries.

"These frontier markets are 10 years behind where Brazil, Russia, India and China are. These are tomorrow's most intriguing growth opportunities," said Claymore Securities President Christian Magoon, noting that the firm had launched the first "BRIC" ETF when it launched its first ETFs about 18 months ago. The Claymore/BNY BRIC ETF (EEB) currently has about $1.2 billion in assets and is up more than 115% from its inception, according to Magoon.

"We wanted to get in front of the growth projected for those countries and launch the first frontier market ETF," he explained. "Similar to our solar ETF, it was only recently that enough companies with large enough market caps existed to create an investable frontier market ETF."

The Index

Given the success of EEB, it is not surprising that Claymore has gone back to the well in terms of the index provider.

"We wanted to partner with an index provider that had expertise in these markets and had the broadest index available," he said.

The index includes only depositary receipts—ADRs or GDRs—which are companies listed on U.S. or other major developed market exchanges. Magoon noted that Bank of New York Mellon is responsible for 64% of the world's depositary receipts.

"There's certain due diligence and qualifications you have to meet as a company to have a depositary receipt. We think that given the volatility of frontier markets, having that extra process in place is a more conservative approach to investing in frontier markets but also a more effective approach," Magoon said.

BNY evaluated countries on an individual basis on five criteria—GDP growth, experienced and expected inflation, per capita income growth, privatization of infrastructure and social inequalities—and came up with 41 countries that fit its definition of what a frontier market is. Individual stocks in those 41 countries were screened according to liquidity, which was a primary concern, according to Magoon, and certainly one of the key concerns of investors delving into nondeveloped markets. The BNY methodology required companies to meet minimum volume requirements as well as have a minimum market capitalization of $100 million and a minimum share prices of $3. Once those screens were applied, however, only companies from 15 countries were eligible for inclusion. BNY will re-evaluate the universe on a quarterly basis.

BNY's definition of what constitutes "frontier" aside, several of the countries represented in the index actually qualify as emerging markets by the standards of some of the major index providers, although there is no cut-and-dried definition of what the difference is between the frontier and emerging designation. In particular, the three largest countries—Poland, Chile and Egypt—are classified as emerging by Dow Jones Indexes, MSCI Barra, Standard & Poor's and FTSE; together, those three countries represent almost 64% of the index. Eight of the top 10 components in the index are from one of these three countries. Other countries with emerging market status in the index include Peru, the Czech Republic, Pakistan and Colombia.

The countries that do not make it into the emerging markets indexes of all of the major global index providers include Kazakhstan, Lebanon, Nigeria, Oman, Croatia, Bahrain, Georgia and the United Arab Emirates; together they amount to nearly 21% of the index's total market capitalization. In what seems like a glaring omission, Vietnam, a darling of frontier market fans that has experienced rather stunning growth, is not included in the index. It apparently did not meet the screening criteria.

Not surprisingly, the index is heavily weighted toward Financials, which weigh in at 37.27%, followed by Telecommunications at 16.24% and Materials at 13.46%. In all, the index has a total market capitalization of more than $110 billion.

FRN charges 65 basis points and is listed on the NYSE Arca.

The Competition

But FRN was not the only frontier markets ETF in the works: Invesco PowerShares has the PowerShares MENA Frontier Countries Portfolio in registration. It announced that the launch of the fund was imminent just yesterday, although the exact date is unknown—or at least not yet public. The fund is expected to list on the NASDAQ Stock Market under the symbol PMNA. Van Eck also has several Market Vectors ETFs in registration that cover various frontier markets, including a global frontier fund and others covering Africa, the Middle East and Vietnam, but there has been no indication as to when those ETFs will launch. (Read the prospectus for the Van Eck funds here.)

The PowerShares ETF tracks the NASDAQ OMX Middle East North Africa Index, which currently includes securities from Egypt, Morocco, Oman, Lebanon, Jordan, Kuwait, Bahrain, Qatar and the United Arab Emirates. Like FRN's underlying index, PMNA's underlying index also includes some countries some of the major index providers would classify as "emerging," such as Egypt, Jordan and Morocco.

Like FRN's underlying index, PMNA's underlying also has liquidity screens in place. Companies must have market capitalizations of at least $200 million and a three-month average daily value traded of at least $1 million. Although the World Bank identifies 18 countries in the MENA region, only the nine listed previously have stocks that meet the index's liquidity criteria.

The fact that the ETF is focused on the Middle East and North Africa means that a large number of frontier markets from South America, Europe and Asia are excluded. PMNA provides more concentrated exposure to two particular regions rather than the broad spectrum of frontier markets. When it launches, it seems likely that its audience will be somewhat different from that of FRN—investors looking to diversify their portfolios on a regional basis or to make a regional bet rather than investors more focused on simply diversifying into a previously unreachable subset of the emerging markets asset class.

(Read the prospectus for PMNA here.)

Why Frontier Markets?

So what's so great about frontier markets? Obviously something, or there wouldn't be a competition for first place in the race to get the first frontier market ETF listed and trading.

Magoon identified three key characteristics of frontier markets that make them attractive to investors: 1) rapid economic growth in terms of GDP, 2) low-to-no correlation with other emerging markets and developed markets, and 3) above-average potential risk paired with above-average potential returns.

Developed markets, hit by the credit crunch among other issues, are looking at GDP growth somewhere between 1% and 3%, Magoon said, while frontier markets are looking at growth ranging from 5% for some markets to 12% for markets such as Georgia. Meanwhile, more developed emerging markets are showing correlations of 0.6 to 0.7 with developed markets when frontier markets' correlations are closer to 0.3.

"I think investors are always looking for an investment that zigs when some of their other investments zag, and I think the low-to-no correlation is a big deal," Magoon commented.

PowerShares Senior Vice President of Portfolio Strategies Ed McRedmond agrees.

"There's the belief that anything outside the U.S. is going to provide you with some asset allocation benefits, but obviously what we've seen over the years with some of the foreign markets is that the correlation has gotten somewhat higher to the U.S market as those markets have developed and become more intertwined with the U.S. market," he noted, adding that the MENA markets are one of the areas that still offer very low correlation to the U.S. market and other foreign markets.

"Because frontier markets have shown such a low correlation to the U.S. markets and to some of the traditional developed market indexes such as EAFE, we believe it's a nice component to someone's portfolio. Any time you can add something to your portfolio that may have a lower correlation to everything else that's in there, over time that may reduce the overall volatility and risk of the entire portfolio," McRedmond said.

Beyond the potential benefits to be found in frontier markets lies the question of how exactly they fit into an investor's portfolio. Claymore's Magoon seems to view it almost as a missing puzzle piece.

"We see it as part of the emerging markets' weighting in an investor's portfolio and a complement to investors' traditional emerging markets investments," Magoon said. "The typical emerging markets investor is getting exposure to more developed emerging markets and not really getting these embryonic emerging markets."

Although that exposure was previously hard to come by, it looks like Claymore is riding the crest of what will be a wave of products designed to give investors access to the most obscure parts of the investable world.

COUNTRY NAME % Poland Bank Pekao S.A. GDS 8.06% Egypt Orascom Telecom Holding GDR 6.38% Poland Telekomunikacja Polska S.A. GDR 6.26% Poland Polski Koncern Naftowy S.A. GDR 5.63% Peru Compania de Minas Buenaventura S.A. ADS 5.39% Kazakhstan KazMunaiGas Exploration & Production GDR 5.23% Chile Empresa Nacional de Electricidad S.A. ADS 5.06% Poland KGHM Polska Miedz S.A. GDS 4.92% Egypt Orascom Construction Industries S.A.E. GDS 4.89% Chile Enersis S.A. ADS 4.44%

COUNTRY % POLAND 24.86% CHILE 21.01% EGYPT 17.73% KAZAKHSTAN 7.72% PERU 5.39% CZECH 5.01% LEBANON 3.09% NIGERIA 3.02% PAKISTAN 2.79% OMAN 2.53% COLOMBIA 2.41% CROATIA 1.79% BAHRAIN 1.38% GEORGIA 0.76% UAE 0.51%

SECTOR % Financials 37.27% Telecommunication Services 16.24% Materials 13.46% Energy 11.61% Utilities 9.50% Industrials 6.84% Consumer Staples 3.06% Health Care 1.51% Consumer Discretionary 0.51%

• More on choosing the right ETF

Comments

[Diego Stend...:]

I am disappointed in not seeing any stocks from Ukraine in the new Frontier etfs - Ukraine is one of the most promising country in the frontier world and it's being completely overlooked

2008 Jun 13 08:45 AM

[ThirstyForA...:]

It's disappointing to see Nigeria as the sole representative, at a tiny 3%, from all of Africa! When will more countries in sub-saharan Africa be included in these so-called frontier market funds ? Growth in that region over the past few years has been phenomenal! Even TRAMX which invests in Africa and the Middle East, has little to no exposure to sub-saharan Africa, barring a significant chunk in South Africa, which is hardly a "frontier" market.

2008 Jun 13 11:38 AM

[David Hunkar:]

I agree with ThirstyForAfrica.South Africa is the most dominant piece in most African funds. Africa is much more than just one country.

Surprising to see Poland at nearly 25%. Is Poland that promising?

2008 Jun 13 12:45 PM