FM: Frontier Markets For The Long Term
Summary
- Frontier markets are cheap by both absolute and relative standards. Few investors bother to invest in them.
- Frontier markets offer true diversification away from developed market politics.
- iShares MSCI Frontier 100 ETF(FM) is far from a perfect vehicle, but it is a simple option for US based investors seeking frontier market exposure.
- The reclassification of Kuwait to emerging market will drastically alter the iShares MSCI Frontier 100 ETF’s portfolio. Overall, the change is likely to make the fund less dependent on resources.
- Recent volatility has made frontier markets even more compelling.
Even after the recent turmoil, US markets are still expensive by historical standards. With the coming election, the US also has geopolitical risk. Rather than hiding in cash, we’re looking for opportunities to invest elsewhere.
Not only are frontier markets already heavily discounted, they also offer the opportunity to truly diversify away from the US, China and Europe. After Invesco shut down its frontier markets ETF, the only US listed broad frontier markets ETF is the iShares MSCI Frontier 100 ETF(NYSEARCA:FM). The impending country reclassification will change FM, making it less of a resource play. Although it's far from a perfect vehicle, it offers a compelling deep value setup in the current market.
Valuation
Frontier markets are cheap and undercovered, compared to both emerging and developed markets. This long term chart, rebased to start at 100, shows just how much frontier markets have lagged other major broad market indices.
FM’s P/E ratio of 11.4 is less than half the P/E ratio of the S&P 500 (SPY), and well below the MSCI EAFE index(EFA), which represents broad developed market exposure outside the US. Frontier markets are also much cheaper than emerging markets. The iShares MSCI Emerging Markets ETF(EEM) has an average P/E ratio of 14.8. Total assets in FM are a tiny fraction of other broad market ETFs as well. The table below compares the size and valuation metrics for FM, and several broad market ETFs representing exposure to emerging and developed markets.
Index | P/E Ratio | Assets |
iShares MSCI Frontier 100 ETF (FM) | 11.4 | $472 million |
iShares MSCI Emerging Markets ETF (EEM) | 14.8 | $25 billion |
iShares MSCI EAFE ETF (EFA) | 17.7 | $57 billion |
SPDR S&P 500 ETF Trust (SPY) | 24.5 | $265 billion |
Sources : ETF.com, Seeking Alpha
Current Country Allocation
FM’s invests in 16 countries that MSCI classifies as frontier markets. The following chart shows assets by country.
Source : Fund website, author's calculations
As the chart shows, a small handful of countries dominate the portfolio. Indeed, the top five countries account for 78% of assets. Yet there is a twist in the story: MSCI recently switched Kuwait's status from frontier to emerging market. Consequently, FM will divest from Kuwait, and EEM will invest in Kuwait, effective May of this year. This has short term and long term consequences for FM investors.
There are many more assets benchmarked to emerging markets than there are frontier markets. In the short term, buying pressure from funds that invest in emerging , but not frontier markets. Reuters cited an estimate from Dubai-based Arqaam capital, that the classification switch would drive at least $2.7 billion in passive flows alone. Active investors would drive another $7 billion at least, according to an estimate from Kuwait and Middle East Financial Investment Company. Kuwait equities have broadly outperformed emerging markets and other frontier markets since MSCI made the announcement last summer. When MSCI made the announcement, some analysts argued that Kuwait’s removal will be negative for the long run performance.
However, in recent weeks, as oil prices have plunged, middle east equities have suffered. Crude petroleum accounts for the ~68% of Kuwait’s exports. A potential succession crisis in Saudi Arabia doesn’t help with regional stability either. It's possible FM will be handing off a falling knife to EEM. In any case, FM will be heavily exposed to Kuwait for the next 2 months. Yet after that the economic exposure offered by FM will change drastically.
New Country Allocations
By dropping Kuwait, FM will stop being a resource dominated investment, and turn into a diversified bet on fast growing undervalued markets. Most other top frontier markets are net oil importers. In most cases they have relatively diversified economies without excess dependence on any one export market or sector. Notably, none of them are dependent on the US economy either.
After dropping Kuwait, FM will likely increase exposure to other top holdings, including Morocco, Vietnam Kenya, Bahrain, and Nigeria. The following table shows the top export products and export markets for these countries. Notably, only Bahrain and Nigeria are focused on resource exports. Additionally, these top frontier market countries do not have excess dependence on China or the United States. With the exception of Morocco, they also have limited exposure to Europe.
Country | Top Exports | Export Markets |
Vietnam | Broadcasting equipment 14%) Telephones (7%) Integrated Circuits (7%) | China (18%) Japan (8%) South Korea(7%) |
Morocco | Cars (11%) Mixed Mineral or Chemical Fertilizers (7%) Insulated Wire(6%) | France (22%) Spain (22%) Germany( 5%) |
Kenya | Tea (22%) Cut Flowers (11%) Refined Petroleum (5%) | United States (9%) Pakistan (9%) Uganda (8%) |
Bahrain | Refined Petroleum( 38%) Raw aluminum (19%) Iron Ore (3.4%) | United State s(17%) South Africa (7%) South Korea (7%) |
Nigeria | Crude Petroleum (76%) Petroleum Gas(14%) Refined Petroleum (2%) | India (18%) United States (14%) Spain(10%) |
Source OEC.World
FM invests in markets that are less correlated to global markets. In contrast, emerging markets are driven primarily by China, which is dependent on exporting to developed markets. In addition to cheap valuation, frontier market provides true diversification not available in many other ETFs.
Industry Exposure
Market cap limitations, and country allocations will ultimately drive sector allocation. Currently FM is heavily exposed to the financial sector in Kuwait. National Bank of Kuwait alone accounts for 11.4%. Some of the largest companies in other frontier markets are also banks. FM will likely increase investments in Ahli United Bank in Nahrain, Banca Transilvan SA in Romania, and Attijariwafa Bank in Morocco. It is likely financials will play a smaller part once the allocations change. How much sector diversification is still uncertain.
Source : Fund website, author's calculations
Conclusion
FM has its limitations. Currently it's too exposed to Kuwait. Even after the coming re-balancing it is likely to be overly focused on financials. Nonetheless, with developed markets absurdly expensive, and emerging markets overly dependent on China, frontier markets provide valuable diversification. Unlike other broad market funds, FM is not dependent on US or Chinese politics. At today's absurdly low valuations, frontier markets are a compelling buy.
This article was written by
Analyst’s Disclosure: I am/we are long FM, EEM. 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.
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