Small World with ETFs: Access Emerging and Frontier Markets

Exchange-traded funds give little guys a shot in the big world of emerging and frontier markets. Travel advisories may apply.

Interested in building mileage for your portfolio without the jet lag? Consider U.S.-listed exchange-traded funds (ETFs) to invest globally. They might help you tap upside potential in the spending habits of the newest middle class or the innovative housing solutions for sheltering a swelling population.

Increasingly, many ETFs reach the fast-growing but volatile pockets of emerging markets and their up-and-coming tagalongs known as frontier markets [What’s a frontier market? See the sidebar below]. Depending on the risk level you can stomach, you might choose a more conservative domestic or developed-world ETF with companies that collect their profits at home and abroad. Or, you may dabble in, for example, a frontier ETF crammed with Middle East oil companies.

There are a couple of big reasons you might include emerging (and, selectively, frontier) exposure. Why else but for diversification (particularly if developed markets are aligned and bonds and stocks are locked at the hip). Then there’s the potential for attractive returns (you must accept the potential for significant losses, too). In the big picture, ETF performance data simply help make this point: economic growth is seldom uniform around the globe and investors are well-served to sniff out areas positioned to potentially outperform—and anticipate when buzz is little more than hype.

Numbers Story

For sure, some ETF performance numbers support the fact that there is a population growth story underway. There are expanding economies full of people who will eat more (and differently), drive new cars, build big apartment buildings and coastal retreats, and gab on their smart phones.

Five of the fastest seven economic growth forecasts for 2013 are frontier markets, reports The Economist magazine*. Behind mature emerging market China (+8.4% GDP growth), and India (6.5%), stand Indonesia (+6.3%), Peru (+6.1%), the Philippines (+5.9%), Chile (+4.8%), and Colombia (+4.6%). Compare those digits to forecasted GDP growth for developed nations like the U.S. (+2.1%), Canada (+1.7%), Japan (1.3%), and the Euro area (-0.5%).

Keep in mind that economic growth and stocks aren’t always tightly correlated. For example, the Chinese Shanghai Composite is still well below its 2009 highs despite economic growth projections. That leads some skeptics to question whether Chinese state-issued economic data paints an accurate picture.

Travel Plans

To get started, pay attention to macro factors: a region’s political and economic stability, including government regulation and transparency; the average age of the working population; restrictions on foreign direct investment; number and quality of trading partners; and access to natural resources.

There are also tactical considerations. Before buying global ETFs (or any ETFs for that matter), consider price and liquidity. A scan of the 1,370 ETFs trading on U.S. exchanges in early 2013 reveals that some 400 were trading above $5 and at a minimum average daily volume of 100,000 shares. In other words, less than one-third of ETFs trade in a volume and price range liquid enough to pass the sniff test of conservative professional traders, money managers, and sophisticated individual investors. Of the 400, roughly 40 cover emerging and frontier stock or bond funds. Of course, investors can tread wherever they like. They just have to keep in mind that less-liquid stocks can have wider spreads that boost the cost of buying and selling. Thinly traded ETFs may be hard to unload in ugly bear markets.

Too Focused?

It’s important to uncover an ETF’s concentration before you jump in. Dozens of companies or countries may fit its criteria but that doesn’t mean the fund holds more than a few select names. This can be beneficial to a fund’s performance in certain periods but can also negate the very reason an investor tapped emerging markets in the first place—diversification. Plus, investors should gauge correlation (importantly, lack of correlation) to U.S. stocks.

Finally, consider fees charged by fund managers. Regulations and small size might translate into a higher cost of doing business. For example, the MSCI Frontier Market 100 Index Fund (FM) charges a 0.79% expense ratio as of April 2013 compared to 0.65% for the Frontier Markets ETF (FRN) or iShares MSCI Emerging Market Index (EEM)’s 0.67%. ETFs that focus their investments on a particular sector such as emerging markets, generally have higher expense ratios than general equity ETFs. International and emerging market ETFs tend to have higher expense ratios than comparable domestic funds. Investors should comparison shop.

Investing in emerging and frontier markets requires country and market homework, plus a fair dose of due diligence on fund managers. Not too many years ago that homework was an exercise in geographical curiosity, or to research the international footprint of a U.S. stock. But as more global markets mature and ETF inventory grows, it’s increasingly possible for retail investors to access market opportunities and to potentially capitalize on the jagged economic growth found across our little spinning sphere.

*Source: Haver Analytics and Economist Intelligence Unit; data and projected data calculated as of April 2013.

Editor’s Note: This article was originally published in May 2013.

Carefully consider the investment objectives, risks, charges, and expenses of an exchange traded fund before investing. A prospectus, obtained by calling 800-669-3900, contains this and other important information about an investment company. Read carefully before investing.