Frontier Markets: Where Few Investors Have Gone Before

As an example of how volatile these markets can be, the Bangladesh stock market sat near the top of Bespoke Investment Group's 2010 list of stock market performance by country, with a 75% return. A year later it was down 33%, and is down another 19% so far this year.

That kind of volatility necessitates diversification, but unfortunately, there's no official definition of what a frontier market is. Standard & Poor's, MSCI Barra, and FTSE all maintain different indexes of frontier market countries, and one indexer's list of frontier countries may include items from another's list of emerging market countries. Muddling things further, some countries have advanced all the way to developed status, but are kept on frontier and emerging indexes for the sake of consistency.

Caveat investor
Despite the confusion, there are a growing number of ETFs seeking to give investors exposure to some of these markets.

But buyer beware!

Currently, the Guggenheim Frontier Markets ETF (NYS: FRN) is the only fund that doesn't focus on a specific global region. But doesn't it really? Fully 72% of the fund's assets are invested in South American countries. Judging by the three main index providers, most of the frontier market countries are in the regions of Eastern Europe, the Middle East, Southeast Asia, and Africa. South America, not so much, and certainly not 72%.

You might try to invest in a basket of region-specific funds, but unfortunately, these often suffer the same problem. Take a look at some emerging and/or frontier market funds and see how concentrated they are in certain countries.

Granted, most of these funds focus on emerging markets, not frontier, but remember that the terms are loosely defined so there's a lot of overlap in the funds' holdings. The point is, if you have to use imperfect funds to get frontier exposure, at least try to use the right imperfect funds.

So what's an investor to do?
What follows is not a list of recommendations per se. If I had my druthers, I'd own an equal-weight index ETF that only owns frontier countries. But if you need the precision of a tack hammer and all you have is a sledgehammer, you put on some Peter Gabriel and try to make it work.

In Africa, the Market Vectors Africa Index ETF (NYS: AFK) seems like the most sensible option. It spreads itself fairly evenly across four different African countries and a roughly equal allocation to London-incorporated-but-Africa-based companies.

Moving east, the WisdomTree Middle East Dividend Fund (NAS: GULF) looks like the best of its bunch. It is similarly concentrated on three or four countries, but it has a greater focus on the emerging middle class than other options, and less on banks. It also sports a generous dividend, averaging about 4%, though payments can be somewhat erratic.

Southeast Asia is home to a surprising number of country-specific ETFs yet few diversified choices. As a result, the Market Vectors Vietnam ETF (NYS: VNM) is the only fund with any frontier exposure in this region.

Finally, there is one other option. Because equity markets in frontier countries are either nonexistent or nearly impossible to invest in, sovereign debt is sometimes the only way to gain exposure. The PowerShares Emerging Markets Sovereign Debt Portfolio (NYS: PCY) is surprisingly well diversified across emerging and frontier market countries, with a weighted-average bond rating of BBB-/Baa3, the lowest possible investment-grade rating. It's an obviously risky play, but so are all of these ideas, and it may help to round out a diversified frontier markets allocation.

The Foolish bottom line
Most of these funds are very new and unproven. There are huge risks in their highly concentrated positions, and even buying all of them would only expose you to a small subset of a proper frontier markets index. That said, these are some of the only ways for the average investor to get exposure to these fledgling markets, and they are at least worth keeping your eye on to see what's out on the investing frontier.

• Add Market Vectors Vietnam ETF to My Watchlist.

• Add PowerShares Emerging Markets Sovereign Debt to My Watchlist.

• Add WisdomTree Middle East Dividend to My Watchlist.

• Add Guggenheim Frontier Markets to My Watchlist.

• Add Market Vectors Africa Index to My Watchlist.

At the time this article was published Fool contributor Jacob Roche holds no position in any of the stocks mentioned. Check out his Motley Fool CAPS profile or follow his articles using Twitter or RSS. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.

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