FM - FM: Wagons East As The Frontier Beckons

Summary

• iShares MSCI Frontier and Select EM ETF tracks an index of frontier markets.
• The FM ETF straddles the line between emerging markets and frontier markets, with a fund objective of an 80/20 split.
• For the layperson, frontier markets are a step down from emerging markets, making them a riskier investment option.
• Many of the holdings in FM are not individual stocks, but collectives that are operated by a single controlling entity, similar to Korean Chaebols.
• We rate FM a Buy, as we believe the frontier is full of opportunity.

By Alex Rosen.

Strategy

Prior to March 2021, iShares MSCI Frontier and Select EM ETF (FM) was called iShares MSCI Frontier 100 ETF, and it simply tracked an index of the top 100 Frontier stocks, or stock collectives. Since that time, the FM fund has repositioned itself to be a more diverse exchange-traded fund ("ETF"). Now FM has broadened its exposure to stocks in frontier and emerging markets.

The fund does not have a cap bias, but prefers smaller holdings in emerging markets. FM uses a group entity model to hold multiple stocks in a single market which are controlled by a single entity. The fund objective is an 80/20 weight split between frontier and emerging markets. The largest frontier countries are capped at 40%, and emerging markets are capped at 5% for any individual market.

Proprietary ETF Grades

• Offense/Defense: Offense

• Segment: Non-U.S. Equity

• Sub-Segment: Emerging/Frontier Markets

• Risk (vs. S&P 500): Low.

Proprietary Technical Ratings*

• Short-Term (next 3 months): A

• Long-Term (next 12 months): A

* Our assessment of reward potential vs. risk taken.

(Rating Scale: A=Excellent, B=Good, C=Fair D=Weak, F=Poor.)

Holding Analysis

As a Frontier Market fund, FM has holdings in countries not typically seen by investors. As of this writing, the largest holding is Vietnam (31%), followed by Romania (7.8%), Kazakhstan (7.5%) and the Philippines (7.1%). From a sector standpoint, the fund is heavily weighted towards financials (38.1%), followed by Materials (11.1%), Real Estate (10.3%), and Consumer Staples (9.9%).

The fund holds 300 individual stocks or group entities. The leading holdings are Kaspi KZ JSC GDR Reg S ((KSPI)) a Kazakhstan payment and Fintech company at 3.7%, USD cash at 2.9%, Banca Transylvania ((TLV)) at 2.8% and Vietcombank ((VCB)) at 2.8%.

Strengths

When writing about emerging markets, it's always the same: China, India, maybe some Brazil. It's almost as if they are a fund unto themselves ( BKF ). FM presents investors with a pleasant change of pace. In the political and economic world, we hear about the winners and losers. Those countries that have fully emerged, and the failed or failing states. Rarely do we hear about the middle states, not too rich, but not too poor. Essentially, the places you think about when considering retiring abroad.

For the most part the frontier market sector is made up of countries with fairly stable economies, reasonably functional governments, and interesting investment opportunities. Not the headline countries, unless you are a fan of Borat or Vampires, but the blue collar workhorse countries that make it possible for the rest of the world to function.

An assessment of the individual stocks is less critical here, as they are subject to change on a regular basis, but an awareness of where those companies are located and what the conditions that they operate under is much more valuable when evaluating the strengths of FM.

Weaknesses

The frontier is vast and it's wild. The countries that make up the frontier market do not have the strongest institutions. Many of them are ruled by strongmen, or in the case of Vietnam, an openly communist government. With any non-democratic government, the biggest fear is a lack of transparency (the same argument can be made for fully democratic countries as well, but that's a different fund analysis). The fund's largest holding, KSPI, is a mix of three entities that provide financial services through an online app.

It is very difficult to separate the countries from the companies, and if the government falls, the companies aligned with them fall as well.

Opportunities

Out of chaos comes order. Supposedly, Nietzsche said that, but I always remember it from Blazing Saddles . It's a story about a frontier market beset by hostile forces. In the end, the sheriff overcomes obstacles to make Rock Ridge once again safe for the people. In developed markets, the opportunity for high returns are limited, as the markets are typically too mature. In frontier markets, there is a distinct possibility that the moon shot may work because the companies are not beholden to things like oversight and government regulations.

Illiberal democracies tend to be led by iron-fisted rulers. Leaders rarely suffer descent, and as a result, companies with the right connections are able to flourish. In the short run, this makes them very attractive to investors.

Threats

Illiberal democracies are a double-edged sword. When they go right, lots of people at the top make money and investors are rewarded. However, when a leader's time is up, don't wait for the elections to see how things turn out. In some countries, like Chile, South Korea and Taiwan, autocratic leaders had the foresight to recognize when they had completed their missions and left amicably. However, in so many other countries, the leaders cling to power as if it were a life and death struggle. For many it is, because there is no exit strategy. They will sooner destroy the country than relinquish power. When this happens, divest as quickly as possible. FM invests in the exact kind of countries where it is an all or nothing proposition.

Conclusions

ETF Quality Opinion

Funds that invest in transparent companies in a plain vanilla model are always attractive. With FM, the model is relatively straightforward, but the underlying stocks are less transparent than we would like them to be. The fund provides exposure to countries that rarely get coverage and that is exciting, but that very lack of coverage makes us wonder what's under the hood.

ETF Investment Opinion

When Russia invaded Ukraine, there were legitimate concerns that the war would quickly spill over into other neighboring countries. As a result, investors were justifiably very concerned about the future of the frontier markets. Now, 11 months into the war, it seems as if those fears were allayed. The last three months has seen iShares MSCI Frontier and Select EM ETF rebound nicely, gaining 10%. As a result we rate FM a Buy, but always pay attention to what's going on under the hood and get out when the engine starts knocking.

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