Braving The Frontier Markets

Courtesy of Barron’s, a look at frontier markets:

Frontier markets are surging this year. Investors, however, should think twice before plunging headlong into stocks from countries as far-flung as Argentina, Bangladesh, Botswana, Slovakia, and Sri Lanka.

The appeal is obvious: The MSCI Frontier Markets Total Return Index has risen 8% since the start of the year, besting the MSCI Emerging Markets Total Return Index’s 0.4% return by 7.6 percentage points.

But frontier markets today are essentially what emerging markets were more than a decade ago—in both positive and negative respects. There’s the outsized growth, sure, but that comes with higher-than-average risks. Most frontier-market stocks trade infrequently, are expensive to enter and exit, and come with idiosyncratic factors that can cause markets to plunge or freeze up completely. It’s not a bet for the faint of heart—or an easy market to play. “It makes sense to have some exposure,” says David Romhilt, head of manager research for the Americas at Barclays in New York. “But there are real risks in the space.”

FRONTIER MARKETS HAVE A lot to recommend them. HSBC strategist John Lomax points to their high expected-growth rates and hefty dividends, which average about 5%, compared with just a 2.7% yield in emerging markets. Even better, frontier markets generally outperform emerging markets as investors feel comfortable heading for the more remote reaches of the world’s stock markets—which would be right about now.

There is no ideal way of getting exposure, however. Individual stocks are out of the question. The average frontier fund, meanwhile, has an expense ratio of more than 2%—well above the 1.6% average for emerging-market funds. And that doesn’t factor in the cost of getting in and out of the illiquid securities, which can cost as much as two percentage points of a round-trip trade. The exchange-traded funds dedicated to the asset class are either thinly traded—the iShares MSCI Frontier 100 Index ETF (ticker: FM) averages just 17,000 shares a day—or a pale representation of the asset class. The Guggenheim Frontier Markets ETF (FRN) has 42% of its portfolio in Chile, a country not in any traditional frontier index, and has returned just 3.2% this year.

Worse still, get the timing wrong and frontier markets can hold a portfolio back. The MSCI Frontier Market Index has beaten the MSCI Emerging Market Index just three times during the past 10 years, while returning 9.2% annually versus the emerging market’s 15.5%. And the markets have a habit of blowing up. Vietnam, for instance, dropped 75% from its peak in February 2007 through early March 2009—and a buy-and-hold investor would still be down 46% today.

A better option: Look for an emerging-market mutual fund that doesn’t mind dabbling in frontier markets, counsels Sam Katzman, chief investment officer at Constellation Wealth Advisors. “Frontier markets can be dangerous,” he says. “We look to the emerging-market manager to provide the exposure he’s comfortable with.” But investors will have to stick with smaller emerging-market funds, says Barclay’s Romhilt. That’s because frontier markets are so tiny, only smaller funds are able to build meaningful positions in frontier stocks.

One example: The $1.1 billion Driehaus Emerging Markets Growth Fund (DREGX), which has 1.6% of its portfolio in Nigeria, 1.2% in Qatar, 1.2% in the United Arab Emirates, 1% in Saudi Arabia, and 0.6% in Pakistan. The fund has returned 3.4% this year and 12% annually during the past three. 

This entry was posted on Sunday, February 10th, 2013 at 11:50 pm and is filed under Uncategorized.  You can follow any responses to this entry through the RSS 2.0 feed.  Both comments and pings are currently closed. 

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Wildcats & Black Sheep is a personal interest blog dedicated to the identification and evaluation of maverick investment opportunities arising in frontier - and, what some may consider to be, “rogue” or “black sheep” - markets around the world.

Focusing primarily on The New Seven Sisters - the largely state owned petroleum companies from the emerging world that have become key players in the oil & gas industry as identified by Carola Hoyos, Chief Energy Correspondent for The Financial Times - but spanning other nascent opportunities around the globe that may hold potential in the years ahead, Wildcats & Black Sheep is a place for the adventurous to contemplate & evaluate the emerging markets of tomorrow.