For once, some practical advice on investing in frontier markets

Bubbles happen all the time in frontier markets. The index in Ghana is up 50% in four months. Assuming you wanted to take the risk, what are the safest investment vehicles and do their returns really represent the mouth-watering  headline numbers?

While I was waiting for my interview on a radio program, I overheard the interview of the guest before me. I assume that he was from some sort of sell side firm, because he was touting the benefits of investing in frontier markets. From my viewpoint this was silly.


Frontier markets are volatile, divorced from fundamentals, lack supervision and corporate governance. If you want to invest in the growth of frontier markets there are much better ways to do it. But, I started to questions my convictions. I had just read another article about some small market showing increases of 50%. In this case, it was the Ghana Stock Exchange.


The GSE-Composite Index (GSE-CI) has now risen 50% since the start of the year. I believe that this rise is one of the unintended consequences of central banks’ monetary policy rather than a reflection of fundamental growth. Still someone made money.


So rather than just look at the risks, I asked myself a different question. These bubbles happen all the time in these small markets. Assuming you wanted to take the risk, how could you invest? What are the safest investment vehicles and do their returns really represent the mouth-watering headline numbers?


I started with a website sponsored by CNN This had a graphic that allowed you to point at various markets to determine their gains. One of the best performing markets was not a developed country at all, but Japan. Again, the promise of unlimited free money forever resulted in a 46% increase in the Nikkei 225 since the beginning of the year. The increase might be great for the Japanese, but for others might not so much. The reason has to do with the yen. The actions of the Japanese central bank have debased the yen. An investment in dollars would not have been so successful. A popular ETF, iShares MSCI Japan Index (EWJ), quoted in dollars has risen but only by 16%.


The next best performing stock market was that of the United Arab Emirates (UAE). Its market increased by 28%. The problem with investing in the UAE is that to match the market you would have to physically own all of its components. There is a similar problem with other frontier markets. There are not any ETFs that represent the particular country’s market. However, there are ETFs that do invest a region, which includes the target country’s market.

The closest one for the UAE is the DFM General Market Vectors Gulf States Index ETF (MES).


Fortunately, there is another Gulf States market that has performed very well this year. The Kuwait market has risen 23%. MES does have holdings in both the UAE and Kuwait, but it has not performed anywhere near as well as either market. This year it went from $20.58 to $23.76. This is only 16% increase. The ETF is also tiny. Its capitalization is only $11 million shares. Its average trading volume is only 2,700 a day. Therefore, a block trade could move the market, at least temporarily. The ETF trades in a very tight range. In October 2009, it was trading at $23.91 just a bit lower than it is today. So, the idea that these markets are good diversifications for term investors is not true.


In contrast to the Gulf States markets, is one of the recent stars of the Frontier markets: the Philippines. It stock market has risen from 5,860 to 7,070 in this year alone, a rise of 20%. Since last April, it has risen 35%. Investing in the Philippines is easier than investing in the Gulf. It does have a dedicated ETF: MSCI Philippines Investable Market Index Fund (EPHE). Even better EPHE has tended to match the performance of the index. It has risen almost 20% this year. Since last April, it did even better than the index returning a 41% gain. It has a large capitalization of $414 million and good volume. It trades an average of 370,000 shares a day.


EPHE also represents some of the problems with these markets and these investments. These markets, even large emerging markets like Brazil, Russia and China tend to be very concentrated in a few companies. For example in the Brazilian market, the top five companies make up 48% of the total market value. On the Russian market, the top five make up about 45% of the market and in China, the top 5 make up about 30% of the market. The markets are not only concentrated by companies, they are concentrated by sectors. Russia’s market is dominated by commodities companies. China is more like most frontier markets. It is dominated by financial companies. EPHE is like China, 40% of its holdings are financial with 10% in telecommunications.


Like the Gulf States, three other of the best performing markets are not represented by ETFs: Argentina, Nigeria, Kenya and Botswana. Each of these markets did well this year: Argentina 27%, Nigeria 19%, Kenya 15% and Botswana 16%. However, if you want to invest in Africa there are only two ETFs SPDR S&P Emerging Middle East & Africa (GAF) and Market Vectors Africa Index ETF (AFK). Both of these ETFs lost money since the beginning of the year.


Two contrasting markets are Vietnam and Indonesia. Both markets have gone up this year by about the same amount: Vietnam by 13% and Indonesia by 14%. Their ETFs have not. Both ETFs are very similar. They both have a capitalization of about $450 million. There is a large difference in performance. The Indonesia ETF has increased by 13% this year exactly reflecting the increase in the Indonesia index, while the Vietnam ETF has increased by only 4.8% a fraction of the index.


Cashing in on the headline numbers is a bit of a challenge. It is possible in some markets, while others should simply be avoided. The one thing that is consistent in analysing these investment vehicles is that like anything else, they entail risk often quite a lot. Growth in developing countries is far from a one-way bet. Right now, some of the free money from Japan will probably leak into countries like the Philippines and Indonesia, which might make them attractive investments assuming you trust central bankers will continue the largest economic experiment in history.    


(William Gamble is president of Emerging Market Strategies. An international lawyer and economist, he developed his theories beginning with his first-hand experience and business dealings in the Russia starting in 1993. Mr Gamble holds two graduate law degrees. He was educated at Institute D'Etudes Politique, Trinity College, University of Miami School of Law, and University of Virginia Darden Graduate School of Business Administration. He was a member of the bar in three states, over four different federal courts and has spoken four languages.)

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