Frontier Markets

Frontier Markets—Tread Carefully Says FINRA

Frontier Markets

The frontier markets consist of developing countries that have not yet made it to or have dropped out of the category of emerging markets. Some examples would be Argentina, Lebanon, Nigeria, Slovenia, and Vietnam. If these names conjure up images of hyperinflation, debt default, currency devaluation, government seizure of private property, civil war, corruption, and overall political instability, then you will understand why frontier markets are considered a very high risk corner of the market. The Financial Industry Regulatory Authority (FINRA) recently issued an investor alert on frontier funds titled “Frontier Funds—Travel with Care”.

The advice given by FINRA is fairly generic, including things like knowing which particular frontier markets your fund is investing in, staying on top of costs, and being cognizant of all the risks mentioned above. Three of the major index providers (S&P, MSCI, and FTSE) have frontier markets indexes, but there are substantial differences as to which countries are included how they are weighted. As of now, we are aware of only one exchange-traded fund (ETF) that tracks one of these indexes (iShares MSCI Frontier 100—ticker is FM). The index has six calendar years of data (2008 through 2013), but the ETF has only one (2013). In looking at the 2013 returns data, an important fact emerges; although the return gained by the fund managers lagged the index by only 0.3%, the return realized by investors lagged it by 2.2% because of the discrepancy between the price and the net asset value of the ETF. These discrepancies tend to occur with ETFs that are based on highly illiquid securities, and frontier markets are the most illiquid of all financial markets. For year-to-date 8/31/2014 data, a similar pattern emerges with the fund lagging the index by 0.5% but investors in the fund lagging it by 1.6%.

At this time, IFA does not advise investing in frontier markets, as the risks and costs appear to outweigh the benefits. Since frontier markets make up less than 1% of the global market capitalization, they are unlikely to move the needle in investor’s portfolios unless they massively overweight them, which would mean taking on substantially higher risks. If there is indeed a return premium associated with taking on political risk, then it appears to us that emerging markets will adequately capture it in a less costly manner. At the beginning of 2013, Vanguard Research published their own study1 that reached this same conclusion.  Anyone expecting Vanguard to release an index fund based on frontier markets  should not be holding their breath.

 

1Philips, Christopher B., and Redding, Brad. “Exploring the Next Frontier: A Review of Frontier Equity Markets,” Vanguard Research, January 2013.