Frontier Markets ETFs: Similar In Name Only

Includes: EEM, FM, FRN, MES, PMNA
by: James Picerno

So-called frontier markets—the smaller and less-liquid slice of emerging markets—are attracting a lot of attention these days, inspiring the question: Should I add this slice of the world's equity markets to my asset allocation? Maybe, but a lot depends on how a fund defines "frontier." No less important is the current structure of your existing portfolio.

As an example, let's consider three ETFs in the frontier markets realm relative to one of the more widely held emerging market funds, iShares MSCI Emerging Markets (NYSEARCA:EEM). As you can see in the chart below, the performance of the frontier markets beta can and does vary quite a lot from product to product. On a year-to-date basis through yesterday, September 9, 2013, two of three frontier market ETFs have outperformed EEM by a wide margin. By contrast, one frontier markets product has lagged by a considerable degree. The source of the wide array of returns is closely tied to the funds' benchmarks, which no one will confuse as comparable. Definitions in this space are driven by a mix of creative thinking along with the data.

The two frontier ETFs so far this year that have outperformed EEM—iShares MSCI Frontier 100 (NYSEARCA:FM) and PowerShares MENA Frontier Countries (NASDAQ:PMNA)—are heavily weighted in countries in the Gulf states in the Middle East, a region that's generated strong returns in 2013 through September. By contrast, the lagging frontier fund, Guggenheim Frontier Markets (NYSEARCA:FRN), has no exposure to the Gulf states within its top-five holdings and instead is heavily weighted in countries in Latin America, according to the fund's website.

For another view of how important the weighting in Gulf states has been this year, consider the performance of a fund that routinely targets this region. The next chart compares the relative performance of this year's leading frontier market ETF (FM) with EEM (which has no Gulf states exposure in its top-five country weights) and a dedicated Gulf states ETF—Market Vectors Gulf States Index ETF (NYSEARCA:MES). As you can see, MES has handily won the performance race on a year-to-date basis. Regional allocations, in other words, sometimes explain a lot.

The lesson is that the definition of "frontier" market varies quite a bit, which means that the differences can deliver substantially different results, for both risk and return. For the moment, a bias for Gulf states has been kind to frontier markets strategies, but it would be naïve to think that this edge is permanent. If and when equities in Latin America catch fire again, and/or Gulf states markets stumble, FRN may take the lead over FM and PMNA.

Meanwhile, consider how your existing portfolio stacks up for deciding if a dedicated frontier market allocation is worthwhile. Depending on the product, adding a frontier market product may be redundant to your current holdings.

These two factors together—your current allocation and the frontier markets fund you select—will determine if adding one of these products has merit. But choose carefully, and for the right reason. Too many investors may be investing in frontier market ETFs for the wrong reason: strong recent performance, at least for some products. Even if you think that adding a frontier markets fund to your strategy will be a net plus as a strategic matter, you're still not off the hook. Frontier markets products, after all, are only similar in name.

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