ETFs: The final frontier

The recent Egypt crisis and turmoil across the region has brought to the fore risks of investing in frontier markets. Paul Burgin looks at investment prospects and the issues to consider

The prolonged closure of the Egyptian stock exchange at the end of January highlights one of the many perils facing frontier market investors. Liquidity, access, political and social risk are just some of the factors that must be taken into account. Not surprisingly, investors are far less keen on frontiers than the more tried and tested mainstream emerging markets and they are also hampered by a lack of ETF product choice.

Last year investors switched their equity focus away from developed markets in a bid to unearth outperformance in emerging economies. Global net new assets in emerging market equity ETFs hit $42bn at year end, up from $34.5bn in 2009, accounting for roughly a quarter of all new assets across the ETF universe.

Vanguard Emerging Market and iShares MSCI Emerging Markets rank in the global top three ETFs by AUM.

Christos Costandinides, ETF strategist at Deutsche Bank, says European investors have been keen on the emerging market theme over the last year. He says: “More European money went into emerging markets than into developed markets, by a factor of two.”

A year of expansion
Over the last 12 months, investors sought out broad emerging market indices and the growing number of country specific ETFs. Costandinides calculates that half of all flows went to single country offers. Most of that money was targeted at the BRIC nations, although other non-mainstream products garnered interest, including Vietnam and Sri Lanka funds. Deutsche Bank calculates flows of €148m into Vietnam ETFs and €81m into Malaysian vehicles.

Yet other frontier funds have failed to attract significant interest. In December, EasyETF announced the closure of several focused frontier products, narrowing investors’ choice. Amongst a list of 15 funds scheduled for closure on the 15 December were EasyETF’s Egypt Titans 20, Kuwait Titans 30, United Arab Emirates and South Africa FTSE/JSE Top 40 funds.

Ben Johnson, ETF strategist, says under-developed local capital markets and higher risks make frontier products a difficult option for providers and investors. Multi-country products are the most popular, but remain small by comparison with their mainstream emerging market equivalents. Johnson says: “The biggest product in Europe is the db x-trackers Select Frontiers, but that only has assets of around €70m.”

Single country frontier funds are also in short supply. Johnson says they tend to be smaller than multi-country funds and thinly traded. He believes the Lyxor Kuwait product is one of the largest with assets around $50m. Others, however, are considerably smaller. Johnson wonders how much of their assets are seed money from sponsors and how much is ‘real’ money from investors.

Johnson also believes investors will have to wait a long time to realise value in frontier markets. He says: “Long term thinking has to be very long term. You have to think about your investment thesis. Will an emerging middle class consumer appear and wield a fatter wallet? When? If so, do you want exposure to local firms or Unilever?”

In the meantime, he suggests investors look to minimise risks and seek alternatives to direct frontier investing. Sheridan Admans, investment adviser at UK stockbroker The Share Centre, thinks the rationale behind issuing frontier ETFs is flawed. He says: “The reason they are frontier markets is because they are unbelievably inefficient markets. Poor regulatory and accounting controls, political intervention and tightly owned family businesses mean asset prices are not always to be believed.”

Admans says investors should delay moving into frontier ETFs and opt for actively managed mutual funds instead. Goldman Sachs, BlackRock and Schroders have recently launched such vehicles.

ETF providers that press ahead with product development face significant issues. London or Frankfurt listed products trade when their underlying components are not trading, due to differences in time zones. Spreads can widen significantly when timing goes against investors. Costandinides thinks tracking errors have been relatively well contained nonetheless. He says: “Tracking error is usually under 50 basis points in emerging markets, which compares well with futures and mutual funds.”