Fighting Correlations With Frontier Market ETFs

Among the scores of new ETFs to debut this year has been an addition to the frontier markets fray, the iShares MSCI Frontier 100 Index Fund (NYSE:FM). That ETF launched about 11 weeks ago and since then has accumulated $14.3 million in assets under management.

As the name implies, the iShares MSCI Frontier 100 Index Fund is designed to hold the 100 largest frontier market firms as designated by index provider MSCI (NYSE:MSCI). The rub with the frontier markets designation is that it implies a degree of risk that is higher than that of emerging markets.

Take the example of Argentina, which accounts for almost 3.4 percent of FM's weight. Over the years, investors have warmed to Brazil and Chile. Colombia and Peru, two Latin American markets with perceived higher risks, have also caught investors' attention. However, Argentina is now in danger of losing its frontier status due to the government's anti-foreign investment practices.

In other words, asking investors to warm to the likes of Brazil, China, India and Indonesia is one thing. Asking them to embrace Argentina, Nigeria and almost any country ending in "-stan" is another ballgame altogether. Still, there are some fundamental advantages to investing in frontier markets.

"Additionally, about 30% of the total global population is spread across Frontier nations, while forecasts have many of the Frontier nations among the world's fastest growing economies," said David Chojnacki, Street One Financial market technician, in a research note. "Frontier nations that MSCI includes in their universe include Kuwait, Qatar, UAE, Nigeria, Kazakhstan, Pakistan, Argentina, Oman, Vietnam, and Kenya and we point out that these nations have demonstrated rather low intra-market correlations over time. These low relative correlations ends up adding a positive element to broader portfolios in terms of the addition of non-correlated assets."

iShares previously said frontier markets had a three-year correlation to U.S. stocks of just 0.5, Chojnacki noted. The $154.7 million Guggenheim Frontier Markets ETF (NYSE:FRN) has a three-year correlation to the SPDR S&P 500 (NYSE:SPY) of just 0.27, according to State Street data.

FRN, which debuted in June 2008, stands as the most noteworthy rival to FM, but the former is not a pure play on frontier markets. Chile, Colombia and Peru, all emerging markets, combine for over 63 percent of FRN's weight. Kuwait, Qatar, Nigeria and the United Arab Emirates, all considered frontier markets, combine for almost 71 percent of FM's weight.

By way of the frontier markets' low correlations to U.S. equities, FM has another potential advantage: Lower volatility.

"Interestingly, despite what popular convention may suggest, Frontier Markets have demonstrated much less volatility than both the MSCI Emerging Markets Index as well as the S&P 500 Index in both the financial crisis of 2008 as well as in the current day marketplace," wrote Chojnacki.

FM is home to nearly 100 stocks and charges 0.79 percent per year.

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