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Frontier Markets

|Includes:BKF, EEM, iShares MSCI Brazil Capped ETF (EWZ), GMM, ILF, VWO

Both emerging markets and the emerging marketing campaign led by the famous BRIC countries as propounded by Goldman Sachs and James O'Neill have been very successful. To repeat the success, the modern marketing ‘MadMen’ of Wall Street have created a new asset: Frontier Markets. Even the venerable Financial Times describes these markets as "a lot like emerging markets a generation ago". So these assets are being sold as a chance to get in on the ground floor of a no lose growth story.

A good example of frontier markets is the MSCI Frontier Emerging Markets Index of 26 countries, which basically includes every market not part of another index. A little more discriminating is the selection of the ever inventive Goldman Sachs. Called imaginatively the Goldman 11, these countries include South Korea, Mexico, Indonesia, Turkey, the Philippines, Egypt, Vietnam, Pakistan, Nigeria, Bangladesh and Iran.

In an attempt to replicate the success of the BRIC brand, there are the CIVETS. These include Columbia, Indonesia, Vietnam, Egypt, Turkey and South Africa. The choice of the civet, a mammal, might be accurate. The civet is known for two things: creating very expensive coffee by ingesting and excreting the coffee bean and potentially being the source for an interspecies virus known as SARS (severe acute respiratory syndrome).

Despite the odd names, there is some truth to the Frontier Market "Story". In the last six months of 2010, the MSCI Frontier Markets Index did outperform the emerging markets by gaining 16.5% against 12.3%. Of course this is a rather recent phenomenon. After doing quite well from 2003 to mid-2008, frontier markets collapsed. Like all markets, frontier markets did recover, but until recently they underperformed not only the emerging market index by 27% but the S&P 500 as well.

In terms of economic growth, these matkets are very attractive with some of the fastest growing economies in the world. Their debt burden is often lower than both emerging and develop markets. Their growth seems generally to have a lower correlation to both emerging and develop markets and at 13 times earnings their equities seem quite cheap. Besides they all have growing populations with young cheap labor.

But the happy talk only goes so far. There is another side of the story. First, other than marketing, the grouping of frontier markets has no purpose. To place countries as different as Kuwait, Argentina, Bangladesh, Kenya and Estonia in the same group is simply silly. These countries, their markets, economies and growth prospects have really nothing to do with each other.

Many of the problems for investors in these countries are similar to those in other emerging markets except on steroids. Their legal infrastructures are exceptionally economically inefficient if they exist at all. Many have high levels of political instability and some are nearly failed states. According to Transparency International's Corruption Index, there are countries in this group like Qatar and Estonia which rank fairly well, 19 and 26 respectively. Most do not. Few rank even in the top 100. Countries like Bangladesh, Nigeria and Philippines are all tied at 134.

Like many emerging market, they are dominated by state owned and family owned companies. According to one ranking provided by the Asian Corporate Governance Association, their corporate governance is rather low. Indonesia and Philippines ranked at the bottom for Asia with scores of 40 and 37 respectively. In contrast, Singapore has a score of 67 out of 100.

Their labor forces are young, but sadly their economies are often growing too slowly to provide jobs. Unemployment rates among younger workers are often as high as 40%. Education does not seem to help. According to the IMF in Egypt, Jordan and Tunisia the unemployment rate exceeds 15% even for those workers with a tertiary education and their governments paid the price.

Also the growth assumptions may be dependent on some potentially short term effects. For example the African investment story is based on a belief that Chinese demand will continue. According to recent research at the IMF, the quantitative monetary easing (QE2) in the US has transferred itself almost completely to emerging markets.

The result is often highly volatile markets. Presently Chile, Peru, Indonesia, Philippines, Sri Lanka, Taiwan and Thailand are all at or near all-time highs. In the past, many of these markets have dropped enormous amounts. Egypt in 2008 dropped 60%. While this was similar to the S&P 500, its recovery has not. While the S&P 500 is only 17% off its all-time high, Egypt is still 36% below its peak. Kuwait has recovered only 4% since 2008 and is still 54% off its all-time high. Saudi Arabia reached its peak in 2006. Even after 5 years it is trading at only 35% of its peak.

While the promise is there, it is exceptionally important for the investor to make sophisticated distinctions between these markets. Strategies that might be applicable to more develop markets have no use in frontier markets. And as always, new highs should be a signal for caution rather than the promise of greater profits.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.