Frontier Market ETFs Diverge from the Pack

The previously high-flying frontier markets and related exchange traded funds have been falling behind this year as regional risks finally catch up to the asset class.

The iShares MSCI Frontier 100 ETF (NYSEArca: FM) was among the best performers over 2014, but the fund has declined 13.2% year-to-date, underperforming the MSCI Emerging Markets Index by over 400 basis points.

“Many of the large frontier markets, such as Nigeria, Kenya, Kuwait, and Argentina, all saw their respective stock markets, and currencies, exhibit sharp declines in 2015,” writes Patricia Oey, senior analyst at Morningstar. “There are a number of reasons for these declines, including weak global demand for these countries’ exports, political instability, and terrorism. These issues have weighed on these countries’ public finances, stock markets, and currencies.”

FM includes a heavy tilt toward Kuwait 25.9%, along with Argentina 14.4%, Nigeria 13.4%, Pakistan 10.4%, Kenya 5.9%, Oman 5.8%, Morocco 5.3%, Romania 4.6%, Vietnam 3.6%, Bangladesh 3.2%, Sri Lanka 2.5% and Kazakhstan 2.3%.

If investors are still interested in the frontier markets, though, Oey suggests investing in a diversified fund, which may mitigate the idiosyncratic risks of diving into individual frontier countries.

“Given the volatility of individual frontier-markets countries and currencies, investors are usually better served holding frontier-markets funds that are more geographically diversified,” Oey added.

These frontier markets include countries with underdeveloped institutions, basic financial systems, precarious political systems and fairly illiquid capital markets. Consequently, the region is considered among the riskiest in the global markets.

However, the frontier markets do hold some appeal. For instance, many of these frontier economies are at the early stages of development relative to emerging markets, with growth in the mid- to high-single-digit range. Many countries also have favorable demographics, are expected to increase infrastructure spending and have large natural resource reserves.