Don't Forget Frontier Markets

Summary

• Frontier markets are countries that are too small or illiquid to qualify as emerging markets, but still have investment potential.
• Options for investing in frontier markets are limited, frequently characterized by lack of liquidity and high expenses.
• Despite these issues, there are good reasons to invest in frontier markets.

Investment Thesis

It is not easy to invest in frontier markets and many investors have no exposure to them. While it will not have a large impact on an investor's portfolio to ignore the frontier markets, the cheap valuations, favorable demographics, and low correlation with other markets make them a worthwhile investment.

Frontier Markets

Frontier markets are countries with investable stock markets, but are too small, illiquid, or unregulated to qualify as emerging markets. Definitions of what exactly constitutes a frontier market vary between the three major index providers, but there is significant overlap between them.

• S&P/Dow Jones has the broadest definition, which includes 35 countries.
• MSCI classifies 33 countries as frontier markets, although only 24 of those appears in its frontier markets index.
• FTSE/Russell has 26 countries in their frontier markets index.

Each index contains securities in South America, Africa, Europe, Asia, and the Middle East, so frontier markets are not exclusive to one region. Some of the largest constituent countries include Argentina, Kuwait, Vietnam, Nigeria, and Romania.

According to FTSE, the market cap of securities in developed markets represents 90.9% of the total world market cap, while emerging markets represent 8.8%. Frontier markets comprise a mere 0.3% of the world's total market cap.

If investors wish to match their investments to the market cap of the world, it would not be out of place to round frontier markets down to 0% and split investments proportionally between the developed and emerging markets. In fact, many investors do just that and have no exposure to frontier markets. But there may be value in investing in frontier markets.

ADRs

For the do-it-yourself investor who dislikes ETFs and mutual funds, there are some opportunities to invest in frontier markets through US stock exchanges. Investing in individual securities from frontier markets is not for the faint of heart, however.

Argentina offers the largest selection of ADRs for stock pickers, with over a dozen trading on the US exchanges with sufficient liquidity to invest in. Stocks in Argentina have done well over the past several years, as market reforms and an improved political outlook spurred investment in the country. Many investors predicted that Argentina would graduate from frontier market status to emerging market status and bid up the stocks leading into the summer, but they ended up being disappointed. Argentina's stocks have since come back down to earth, but this does provide some opportunity.

One stock which caught my eye was BBVA Banco Frances (NYSE:BFR), which is bouncing along near its 52-week lows. It is a bank that provides financial services to large corporations, small companies, and individuals in Argentina and its valuations are fairly attractive. It has a forward P/E of 9.9 and a trailing P/E only slightly higher than that. If the political and economic situation in Argentina continues to improve, I would expect healthy returns from the stock.

Outside of Argentina, options for direct investing in frontier markets are limited. Cyprus, which is considered a frontier market by FTSE and S&P but not by MSCI, has one ADR which trades on US exchanges: QIWI plc (NASDAQ:QIWI). QIWI provides payment services in Russia and the Commonwealth of Independent States. Panama, which is considered a frontier market by the S&P and MSCI but not by FTSE, has two ADRs worth consideration: Banco Latinoamericano de Comercio Exterior (NYSE:BLX) and Copa Holdings (NYSE:CPA). The first is a bank and the second is an airline. As you can see, financials and industrials are well represented among frontier markets.

If you aren't interested in Argentina, Cyprus, or Panama, investing in frontier markets directly is very difficult for the US investor. While there may be opportunities in these three countries, a better approach might be with an ETF or mutual fund.

Mutual Funds And ETFs

My first instinct was to look for actively managed mutual funds, as the illiquid nature of frontier markets would seem to lend itself to outperformance by active management. Emerging markets remain one of the few spaces where active funds can frequently outperform the indexes, and there is enough competitors in the space that one can find reasonable expense ratios and good management if one looks hard enough. I assumed the same would be the case for frontier markets, but I was mistaken.

There is a very limited selection of frontier markets mutual funds, and they are characterized by extremely high initial investment requirements, high annual expenses (of roughly 2%) which often include 12b-1 fees that do not serve investors' interests, and/or front-end loads. Even if you ignore these drawbacks, there are limited pure play frontier market funds to choose from.

If an investor is determined to pay for active management in frontier markets, their best bet would be to find a diversified emerging markets fund that has a broad enough mandate that allows them to also invest in frontier markets. In this way, one could get both emerging and frontier markets exposure at a much more reasonable price.

The ETF world, at least, provides two good options for investing in frontier markets.

• iShares MSCI Frontier 100 Fund (NYSEARCA:FM) - This ETF tracks the MSCI Frontier Markets 100 Index (which actually contains closer to 130 constituents currently). MSCI selects stocks from the entire frontier markets universe with an emphasis on liquidity and the ability of investment professionals to replicate the index. In a sense the index is actively managed by MSCI, which reviews country inclusion annually and company inclusion quarterly. The ETF has an expense ratio of 0.79% with $610 million under management and fairly good liquidity.
• Guggenheim Frontier Markets ETF (NYSEARCA:FRN) - This fund has the longest track record of any frontier markets ETF, with a poorly timed debut in 2008. It is smaller and less liquid than the iShares ETF, but with $71 million under management and expenses of 0.70%, it remains a competitive option. It tracks the BNY Mellon New Frontier Index, which primarily focuses on ADRs and GDRs that trade on New York and London exchanges. The ETF has roughly 90 holdings.

Of the two, my preference is the iShares MSCI Frontier 100 Fund for its greater liquidity, larger number of constituents, and lower correlation with developed markets, despite its slightly higher expense ratio.

The Case For Investing

There are many reasons NOT to invest in frontier markets: high expenses, illiquidity, poor corporate governance, and geopolitical risk foremost among them. This isn't the whole story, though. Most investors are not invested in frontier markets, and this can lead to opportunity.

• Beneficiary of front running and underallocation - Due to home bias and limited choices, most investors are overallocated to the US and other developed markets at the expense of emerging and especially frontier markets. We can see this from the relative market caps of the top ETFs for developed, emerging, and frontier markets, as well as academic literature. The disparity in investment between emerging markets and frontier markets, in particular, leads to an investment boom for countries as they graduate from frontier to emerging status. Take the case of Argentina, which many believed would become an emerging market this summer. Investors drove up shares of Argentinian stocks in preparation of the decision. Even though they were disappointed this time, this process will likely repeat itself when they or another country eventually do enter the emerging markets index and the beneficiary will be the funds that bought the stocks at depressed prices and sell them at elevated prices: namely, frontier markets funds.
• Demographic advantages - While frontier markets only constitute a fraction of a percent of the world's market capitalization, they make up a much greater portion of the world's population. As a group, their population is younger, is growing at a faster pace, is improving from a lower starting point in terms of poverty and illiteracy, and is undergoing quicker urbanization than in more developed parts of the world. While a young and growing population doesn't necessarily equate to improving GDP and stock values, there is a strong relationship.
• Cheaper valuations - Frontier markets trade at a trailing P/E of 13, compared to emerging markets with a P/E of 15, developed non-US markets with a P/E of 18, and US markets with a P/E of 22. Forward P/E levels tell a similar story. While there is certainly good reason that frontier and emerging markets should trade at a lower multiple than US stocks, the disparity is especially large at the moment.
• Lower correlation - Due to the lack of international investment in frontier markets, many of them are driven by local concerns rather than global macroeconomic forces. This translates into lower correlation between frontier markets and developed markets. The iShares MSCI Frontier 100 Fund, for instance, had just a 0.39 correlation with the S&P 500 over the past three years and a 0.60 correlation to non-US developed markets.

I would not advocate an enormous allocation to frontier markets, but there are good arguments to be either equal weight or overweight. I personally am overweight both emerging markets and frontier markets, with a little over 9% in emerging markets and a little over 1% in frontier markets (vs. 8.8% and 0.3% if one attempted to match the market capitalization as described by FTSE), and I'm tempted to increase that exposure even further. I added a frontier markets allocation to my portfolio just this past week with a purchase of shares in the iShares MSCI Frontier 100 Fund.

Conclusion

Many investors are not invested in frontier markets, but there are good reasons for them to be. While I have been keeping my eye on one Argentinian ADR, I've decided that the most attractive way to invest in the diverse world of frontier markets stocks is through an ETF. With strong demographics, cheap valuations, and low correlation with other stocks, frontier markets can make a small but important addition to any portfolio.

Disclosure: I am/we are long FM. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.