Frontier market equities may or may not be the next place for institutional investors to earn exceptional returns, but looking to an exchange-traded fund for that exposure can come with some challenges.
While ETFs can provide quick access to frontier stocks, investing in size and choosing the right index can be difficult.
Until recently, frontier markets have been the small section of liquid securities mostly beyond the reach of large ETF investors. But now that Norges Bank Investment Management has announced that it is looking to increase its exposure to frontier markets, ETF issuers will be challenged to prove that their products are potential solutions.
ETFs offer investors quick, targeted exposure for the short or long term. Yet, ETF trading and share creation is highly dependent on the liquidity and availability of underlying securities, and the ease with which market-making firms and other investors can facilitate trading.
“Frontier markets often have a small number of liquid stocks and accessing the market can be difficult. Lack of futures and derivatives and restriction on short-selling and securities lending also create challenges,” says Deborah Fuhr, managing partner of London-based research firm ETFGI LLP.
Currently, frontier market funds account for just $2.4 billion, or 0.11% of global equity ETF assets, according to ETFGI, with about half in broad-based index funds and half in country-specific funds (mostly Vietnam). Major index providers MSCI Inc., FTSE Group and S&P Dow Jones Indices place the value of frontier market equities between 0.16% and 0.59% of global equity value, according to data from Vanguard Group, Malvern, Pa.
Of a half-dozen U.S. ETFs offering frontier market exposure, only the $800 million iShares MSCI Frontier Markets 100 ETF (FM) has gained traction with more than a handful of investment managers. The MSCI Frontier Markets 100 index screens for frontier market companies that have “room” available for foreign investors.
Over the last year, the ETF has gathered more than $400 million in new assets and truly diverged from middling non-U.S. developed and emerging markets with a 24.8% total return, according to XTF Inc. The ETF will soon shift its country exposures because Qatar and United Arab Emirates, which total more than 16% of fund exposure, are moving to emerging market status, according to MSCI.
As with any passive product, the index matters, including diversification for both countries and sectors. Locally listed frontier market companies draw prominently from financial services, energy, and telecommunications. Some funds include only locally listed securities while others, mostly single-country funds, will include stocks from multiple markets.
Among the largest ETF issuers, Vanguard and State Street Corp., Boston, have yet to test frontier market waters, while other broad-based frontier market ETFs haven't yet drawn large positions from institutional investors. These include the $161 million GlobalX Next Emerging and Frontier Market ETF (EMFM), the $283 million EGShares Beyond BRICs ETF (BBRC), and the $98 million Guggenheim Frontier Markets ETF (FRN), which holds a 40% exposure to Chile, classified by many index firms as an emerging market country.
For institutional investors, however, benchmarking against established indexes, such highly targeted frontier market funds and ETFs bring with them both brand and execution risk.
“Frontier markets introduce real issues for both tracking and spreads,” says Dave Nadig, chief investment officer for research firm ETF.com in San Francisco. “If an investor is looking to put $100 million to work, it's difficult not to be the market.”
For evidence of the challenges of executing across frontier markets, ETF.com looks at the efficiency and tradability of ETFs. Core to efficiency is the median tracking difference between the index and the fund's net asset value, i.e. does the manager outperform its expense ratio through optimization, securities lending etc.? Tradability provides statistics on trading spread, market overlaps and the cost to create new shares.
Working through fund issuers and authorized participants can be one way for institutional investors with direct holdings of frontier market equity investments to move out of a less liquid position. For example, the emerging and frontier market investment team of the $52 billion United Nations Joint Staff Pension Fund, New York, used the iShares Frontier Markets 100 ETF as “a timely investment vehicle to help diversify and foster, to the extent possible, investment in developing countries,” said a spokesman.
While competition for ETF assets is limited, index manufacturers are wrangling for position. In early September, FTSE announced an expansion of its frontier market index series to approach MSCI and S&P Dow Jones in country and company coverage. Russell Investments, Seattle, also runs a frontier index series.