As exchange traded funds (ETFs) expand into “frontier markets,” the credentials or definition of a frontier economy is somewhat unclear.

Marc de Luise of IndexUniverse recently discussed frontier markets and examined a classification system in which frontier markets seem somewhat defined and outlined.

He first looked at the term “frontier” and felt that it was an appropriate name for the countries investors turn to for portfolio diversification. These markets are often characterized by high volatility, low liquidity, and sometimes outstanding performance returns.

The term “frontier markets” seems to have an underlying connotation of an exotic set of markets beyond the “emerging markets.” These frontier markets imply both higher levels of risk and higher levels of return. Also, they have a low correlation to emerging and developed markets. Despite this, there really is no distinct definition of what a frontier market is, especially in the world of financial products and indexing.

There is a system in place that does try to differentiate between frontier markets and its emerging and developed counterparts. In 2003, FTSE created a global standard classification system by conducting a public consultation with more than 100 global investment firms. In the pursuit of a global classification, FTSE was able to develop classification qualities of frontier markets.

Under this classification system, FTSE uses a set of criteria in order to be considered a frontier market. This criteria consists of:

• There must be a formal and independent stock market authority that actively monitors the market.
• There should be no objection to or significant restrictions on or penalties applied to the repatriation of capital and income.
• There should be market-depth information, visibility and a timely trade reporting process, as well as a requirement of international price dissemination.
• There should be but rare incidences of failed trades.
• Clearing and settlement period shorter than T+7 and greater than T+0.
• Minimum size requirement mandating an aggregate domestic company market free float capitalization of $750 million.

As investors consider getting into these frontier markets, it is important to truly evaluate the index behind the investment. As Brad Zigler for IndexUniverse explains, many index providers incorporate emerging market economies with frontier markets in an index labeled “frontier.” These index providers do this in an effort to dampen volatility and enhance liquidity.

Zigler’s advice is to invest in true frontier markets by utilizing an index that has meaning and provides exposure to actual frontier markets, rather than a frontier-emerging hybrid.

At ETF Trends, we see frontier funds providing investors with another tool to access far-flung corners of the world, and illustrate an advantage of ETFs. While they entail bigger risks than more developed markets, investors who can stomach the risk and stick to their sell discipline might find themselves with great opportunities for reward.

All of these ETFs launched this year:

• Claymore/BNY Mellon Frontier Markets (FRN)
• Market Vectors Gulf States ETF (MES)
• Market Vectors Africa ETF (AFK)
• PowerShares MENA Frontier Countries (PMNA)

Tags: AFK, Africa, Emerging Markets, FRN, Frontier Markets, MES, Middle East, PMNA

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