Frontier Markets: 7 Warnings

Includes: FM, MES
by: William Gamble

There seem to be some holes in the emerging markets "story." Many emerging markets are down this year, but according to analysts the long-term outlook for this sector remains solid. Not to worry: If emerging markets are down, just move to the even-riskier frontier markets. Frontier markets have been remarkably resilient to the emerging markets travails. The MSCI Frontier Markets 100 Index (NYSEARCA:FM) is up approximately 15% year to date in dollar terms. Even better, frontier markets are supposed to be cheap. FM currently has a P/E ratio of 15.65 compared to 18.15 for the iShares MSCI Emerging Markets ETF (NYSEARCA:EEM).

But there are things to worry about. The following is a list of seven issues investors should consider before investing in frontier markets.

1. The recent rise of frontier markets has been due to a commodities and consumer credit boom. As China slows and the Fed tightens, both are going away.

2. Frontier markets are relationship-based -- as opposed to rule-based -- systems. They have economically inefficient legal infrastructures that lead to asymmetries of information and distort allocations of capital. This is a recipe for boom and busts. Investors in Brazil had to wait more than 20 years after its bust for it to regain respectable growth.

3. It is very difficult for retail investors to find vehicles to invest in frontier markets. For example, one of the best recently performing markets has been the UAE, which has increased 28%. The safest way to invest would be the DFM General Market Vectors Gulf States Index ETF (NYSEARCA:MES). But it is small ($11 million) and represents other Gulf states. It was up only 16%. Other markets that did well this year include Argentina (up 27%), Nigeria (up 19%), Kenya (up 15%), and Botswana (up 16%). But none of them have their own ETF.

4. These markets (and the BRIC markets) are usually concentrated in a few companies that are often state-owned. These companies are invariably financial or commodities. They often reflect global -- not local -- conditions.

5. The corporate governance is dreadful. The regulatory regimes are appalling. They are all exceptionally corrupt. If the economy is growing, that means that someone is making money, but it may not be investors.

6. The demographic advantage of hoards of young people is more of a disadvantage than advantage. Many of these countries' sole exports are commodities. When it is easier for the elite to extract profits from the ground rather than the economy, there is little incentive to create institutions for sustained growth. This leads to a plethora of uneducated, unemployed, frustrated and angry young people who are a threat to social stability.

7. These markets are very volatile and subject to every sort of financial abuse from insider trading to outright fraud. If you are very lucky you might catch a updraft, but don't count on it being sustained. They are not the new BRICs, new Tigers, Lions, or any other silly acronym.

The first emerging markets boom occurred in 1824. After the Napoleonic wars, interest on British government bonds (consuls) fell to 3%. As a result, there was a search for yield. Investors bought into the bonds of newly created countries like Mexico, Brazil, Columbia, and Guatemala. These bonds were yielding about 6%. By 1826 the market value of Columbia bonds had fallen 50%.

The point here is simple: These markets are different. Utilizing tools created for more established markets, like P/E ratios, may not have to same meaning in these markets. For the past 200 years they have been subject to short bursts of rapid growth, followed by stagnation and often decline. The real basis for sustainable growth is a process that allows for reform. Until these markets can sustain that, they are not suitable for long-term investors.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.