Frontier market stocks, in aggregate, continue to deliver in 2014, even after a very strong 2013. In the year to date, the MSCI Frontier Index (when measured in U.S. dollars) is up 16%, far outpacing the MSCI Emerging Markets Index's return of 4%, and the S&P 500's 3%. Among the diversified frontier funds that trade in the United States, iShares MSCI Frontier 100 FM has been the winner in terms of performance and flows in the first four months of 2014, rising 17% and drawing US$320 million. (There are currently no TSX-listed ETFs that focus on frontier markets.) And although FM is only 18 months old, it is currently the third-largest frontier market fund, with more than US$800 million in assets. This rapid growth in assets can be attributed to the fund's accessibility, relatively low expense ratio, and strong investor interest in frontier markets during the past two years.
FM is facing a big change in country allocations in the coming months when it will sell its United Arab Emirates and Qatari holdings (which in aggregate account for about 40% of the fund) and allocate these proceeds into existing holdings. The fund will implement this change gradually over the next six months, in an effort to mitigate potential execution challenges, as frontier countries tend to have shallow capital markets. Index-tracking funds that invest in relatively illiquid securities face two key challenges--front-running and market-impact costs. While these execution challenges rest of the shoulders of the managers of this fund, investors need to re-evaluate the country and company fundamentals of this fund post-change. After the fund completes its transition in November, its country allocations will look very different from what they are today.
Executing the index change
FM is a passively managed fund that tracks the market-cap-weighted MSCI Frontier 100 Index, a benchmark of 100 frontier stocks that meet certain liquidity thresholds and have sufficient foreign room (the proportion of shares still available to foreign investors relative to the maximum allowed). In June 2013, MSCI announced that it was going to upgrade the United Arab Emirates and Qatar (currently FM's second- and third-largest country allocations at 20% and 19%, respectively) from the MSCI Frontier Index to the MSCI Emerging Markets Index.
The addition of these two countries to the MSCI Emerging Markets Index (which together will account for only about 1% of the index) will occur after the market close on May 30. Funds that track this index, such as iShares MSCI Emerging Markets Index XEM, will implement this change at the same time. However, given the magnitude of the change for the MSCI Frontier 100 Index, the relatively low liquidity of most frontier markets, and the size of the iShares frontier ETF, MSCI has created a transitional index that will gradually implement this change over a six-month period through November 2014. (Vanguard FTSE Emerging Markets VEE employed a similar approach when the fund changed its benchmark to the FTSE Emerging Markets Index, which required it to shed its South Korean holdings).
In addition to lacking depth, frontier markets lack breadth. So not only did MSCI create a six-month transition index for its Frontier 100 Index, it also instituted a few methodology changes for the index. With UAE and Qatari stocks out of the index, the pool of potential constituents decreased significantly. In addition, under the existing methodology, the new index would have significant country concentration, with Kuwait and Nigeria accounting for about 53% of the index. To address these issues, MSCI implemented a number of index methodology changes: first, the index will now consider liquid small caps; second, the index will cap the aggregated weight of the two largest country allocations at 40%, and third, the index will allow the number of constituents to fluctuate between 85 and 115. While market-cap-weighted indexes are typically very straightforward, we can see that in the frontier markets, it is more challenging to ensure that the index is investable and suitably diversified for investors.
Another issue is the risk that FM could incur capital gains as it sells its Qatari and UAE holdings. These holdings have rallied strongly over the past year, but it is almost impossible to estimate the potential capital gains from the index change; for example, purchases over 2014 as a result of recent inflows would have seen much less price appreciation. In addition, the Qatari and UAE markets may decline over the next six months as FM sells these securities. However, it is important to note that as of the fund's last fiscal year-end (Aug. 30, 2013), FM had no loss carryforwards. Funds tend to use loss carryforwards to offset taxable transactions due to index changes.
The investment case: Before the index change
One of the main drivers of FM's performance during the past year has been the fund's overweightings in UAE and Qatari stocks. In the 11 months since MSCI announced that UAE and Qatar were going to be moved to the MSCI Emerging Markets Index, the MSCI UAE Index and MSCI Qatar Index rose 85% and 41%, respectively. Much of this was due to multiple expansion over that period -- the UAE index saw its trailing 12-month price/earnings ratio increase from 14 times to 21 times, while the Qatar index saw a smaller expansion from 13 times to 16 times. More than half of the Qatari and UAE holdings are in bank and property firms that are currently benefiting from a strong property market and rising infrastructure spending.
But fundamentals don't fully explain this recent rally. As a result of this index change, Qatari and UAE stocks will see much stronger investor interest--according to MSCI, there is about US$1.4 trillion benchmarked to the MSCI Emerging Markets Index, about 100 times the US$14.5 billion benchmarked to the MSCI Frontier Index. So investors, both domestic and foreign, have piled into these names during the past 11 months to get ahead of this trend. It is also possible that the estimated free float and foreign room of Qatari and UAE names may be overstated (because of inconsistent shareholder reporting). A lower actual free float essentially would have added more fuel to the recent technical, or herd-driven, rally. If this technical rally continues, FM will benefit less as it sheds its exposure to these countries. But more importantly, this highlights the fact that one of the main drivers of the recent rally in MSCI Frontier Index was the MSCI index change, and not necessarily stellar fundamentals.
Finally, it is important to note that the enormous outperformance of the MSCI Frontier Markets Index over the MSCI Emerging Markets Index (26% versus negative 3%, respectively) in 2013 was somewhat of an outlier. It is easy to make the assumption that faster economic growth in frontier markets is driving market performance. But if we look at the three- and five-year performance of the two indexes through Dec. 31, 2012 (to remove the effect of 2013), we see that frontier markets' relative performance was much more sombre, suggesting that 2013's performance was significantly affected by the technical rally in the Qatari and UAE markets.
| Frontier-markets vs. emerging-markets returns | |||||
| MSCI Frontier | MSCI Emerging | ||||
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| 1-Yr return 2013 | 25.9% | -2.6% | |||
| 3-Yr return to Dec. 31, 2012 | 3.1% | 4.7% | |||
| 5-Yr return to Dec. 31, 2012 | -10.9% | -1.0% | |||
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| Source: Morningstar | |||||
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The investment case: After the index change
The change in the MSCI Frontier 100 Index will result in greater geographic diversification. Currently, Gulf Cooperation Council countries comprise about 60% of FM, and this figure will fall to about 35% after Qatar and the UAE move out of the index. GCC countries are oil- and gas-producing Arab countries along the Persian Gulf that have high GDP per capita, but underdeveloped capital markets with many restrictions on foreign investors. While greater geographic diversification is important, GCC countries tend to be more stable relative to other frontier markets and peg their currency to the U.S. dollar, which usually result in less performance volatility (in U.S. dollar terms). With a smaller allocation to GCC countries, FM's volatility may rise, especially as its allocation in countries such as Argentina and Kazakhstan (which recently have experienced a spike in foreign exchange volatility) rises.
| MSCI Frontier Markets Index sector weightings | |||||
| Sector | Current | New | |||
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| Financials | 57% | 48% | |||
| Telecom | 14% | 16% | |||
| Energy | 11% | 6% | |||
| Consumer Staples | 8% | 14% | |||
| Industrials | 6% | 8% | |||
| Materials | 3% | 5% | |||
| Health Care | 1% | 0% | |||
| Utilities | 1% | 1% | |||
| Info Tech | 0% | 0% | |||
| Consumer Discretionary | 0% | 0% | |||
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| Source: MSCI | |||||
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| MSCI Frontier Markets Index country weightings | |||||
| Country | Current | New | |||
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| Kuwait | 20% | 27% | |||
| UAE | 19% | 0% | |||
| Qatar | 19% | 0% | |||
| Nigeria | 11% | 13% | |||
| Argentina | 5% | 9% | |||
| Pakistan | 4% | 9% | |||
| Kenya | 4% | 7% | |||
| Morocco | 3% | 7% | |||
| Oman | 3% | 7% | |||
| Kazakhstan | 3% | 5% | |||
| Vietnam | 2% | 4% | |||
| Other | 7% | 13% | |||
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| Source: MSCI | |||||
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Kuwait will continue to be the largest country allocation after the index change, but at a larger weighting. Like UAE and Qatar, Kuwait's stock market is dominated by financial-services firms. However, while UAE and Qatar have made international headlines with large infrastructure and real estate projects (such as Dubai Marina and stadiums and related structures for the 2022 World Cup), infrastructure development and foreign direct investment in Kuwait is less robust due to its unstable, democratic political system. On the positive side, Kuwait may benefit from growing investor interest in GCC countries (whose GDP growth is expected to outpace some of the more established emerging-markets countries such as Brazil and Russia), and the country's plans to liberalize foreign investment restrictions.
Nigeria, which will be the fund's second-largest country allocation at 13%, is a fairly diverse economy and is expected to see healthy GDP growth in the medium term. Earlier this year, Nigeria became the largest economy in Africa after it rebased its GDP calculation to account for under-represented and faster-growing sectors of the economy, including telecommunications, banking and entertainment. At this time, this fund's Nigerian holdings are primarily banks. The sector is on much more stable footing after reforms and consolidations over the past five years, and the long-term growth outlook is bright. However, the sector has recently been hurt by new regulations, including higher cash reserve requirements, new rules that reduce fees and commissions, as well as a monetary tightening by the central bank. At a national level, presidential elections in 2015, as well as recent high-profile terrorist acts suggest that there could be some political instability in the near term, which could negatively affect the local stock market performance.
