FM - iShares Frontier And Select EM ETF: Slight Improvement In Frontier Market Sentiment

2023-07-14 09:34:35 ET

Summary

• Frontier Markets declined by 26%, underperforming the MSCI AWI by over 10 percentage points, but the 2023 share price is seen as a solid entry point.
• The iShares MSCI Frontier Markets ETF offers broad exposure to frontier markets and smaller emerging markets like Egypt, with a slight discount to the MSCI Frontier Markets index.
• Despite concerns over recent sovereign debt defaults, the ETF is seen as attractive due to its diversified portfolio, acceptable management fee, and exposure to undervalued markets like Romania and Colombia.

Opportunity Overview

Frontier Markets had a rough year in 2022 , as they declined by 26% and underperformed the MSCI AWI by over ten percentage points. The iShares Frontier and Select EM ETF (FM) has declined by around 3% since I last covered this ETF. Meanwhile, the S&P 500 returned 13.1% during the same time period.

Frontier and emerging markets have not performed very well over the past decade, and 2022 was one of the worst years for these markets.

On a long-term basis, the performance of this ETF has not been that favorable.

2023 is likely a much better entry point for frontier markets and smaller emerging markets, as valuations are more compelling and certain macro risks, such as inflation, are relatively lower. There is ample room for selective shopping in smaller and emerging markets.

This ETF provides solid exposure to frontier markets and several smaller emerging markets like Egypt. Furthermore, some of the index rebalancing has been favorable in my view, as it has increased its weighting in attractively valued markets and reduced exposure to some risky markets, like Nigeria.

If you want broad exposure to frontier markets at a slight discount to the MSCI Frontier Markets index, this is a good ETF to consider. There are no index tracking errors, and it invests in a strongly diversified basket of locally listed equities. Moreover, the management fee is acceptably low, at 0.8% .

I also think it is worthwhile to bet on certain smaller emerging markets like Pakistan, Egypt, and Colombia, to name a few. This ETF invests in all three of these markets. There are also single-country ETFs available for all of these countries.

What has changed since my last coverage

Several factors have led me to become more bullish on the outlook for frontier market equities.

Inflation was a much larger risk in 2022, which had a particularly strong impact on countries vulnerable due to dependency on food and energy imports. Inflation has improved in a large number of markets, primarily in select markets in Latin America and Asia, which should help support consumer sentiment. This frontier market ETF invests in a lot of consumer, real estate and healthcare companies, which may perform better in a lower inflation environment.

Many frontier market currencies, such as the Pakistani Rupee and the Egyptian pound , were in much worse shape in late 2022. However, the subsequent devaluation has increased the appeal of these country's exports, and equity markets in many countries like this have fallen to a record low on the back of currency concerns. 2023 is a much better time to begin accumulating, as many of these currencies have begun to stabilize.

The growth outlook in many of these frontier markets has improved. Vietnam, the largest country in this ETF, is projected to grow at 6.3% in 2023 , which is very attractive on a historical basis. However, other markets may struggle due to slower global growth , as many economies are dependent on export growth. My main reservations at the moment include the risks of sovereign debt defaults in some of these countries. Moreover, global growth is declining, and many of these frontier market economies heavily depend on trade for growth. I think this ETF is well positioned to capture the growth trends in frontier and emerging markets. Moreover, this ETF also changed its country exposure to include less exposure to select risky markets.

Frontier Markets Valuation

MSCI frontier markets trade at what I believe is a very attractive valuation . Frontier markets trade at a circa 20% discount to emerging markets, which seems relatively undervalued. It is very easy to access frontier markets/smaller emerging markets at a single digital PE ratio.

Select smaller emerging markets trade at a discount to the MSCI Frontier markets Index. Some of these markets make up 4% or more of the iShares MSCI Frontier Markets ETF.

Source: MSCI (only two-three companies for markets like Pakistan and Egypt)

Inflation Improves Slightly in 2023

One of the main macro risks that frontier markets have been facing is increased inflation. However, inflation has improved in many of these markets, as the primary driver was food/energy inflation in 2022.

Inflation in frontier markets peaked at the beginning of 2023 and is beginning to decline in many frontier and smaller emerging markets. Many Emerging Market Central Banks were able to lower inflation by hiking interest rates relatively early.

Some of the main markets with higher inflation include markets in Europe and select countries in Africa, like Nigeria.

Source: Trading Economics

ETF Overview

This iShares Frontier and Select EM ETF trades at a very attractive valuation and invests in over 160 listed equities in frontier markets. It currently has a P/E ratio of 9.33 and trades at 1.55x book value.

Around 43% of this ETF's assets include materials and financial companies, which is one reason for the slightly lower valuation.

This ETF provides strong exposure to Vietnam (over 3 percentage points higher than the MSCI Frontier Markets Index). It also bets on smaller emerging markets. Some of the smaller emerging markets with frontier characteristics include the Philippines, Colombia, Egypt, and Pakistan.

Other markets, like Kazakhstan, Romania, Bangladesh, and Morocco are very difficult to access when limited to US exchanges. 7 of the top 12 countries listed here have individual ETF products, and some of these markets also have ADRs. However, there are not a lot of investment products available for these markets, relative to larger emerging markets like Taiwan, Brazil, and Indonesia.

The collective population of these top 12 countries is over 1 billion, and it accounts for around 13.8% of the world's population. Specifically, countries like Nigeria, Bangladesh, Pakistan and Egypt could come into focus in the coming decades due to their large populations and favorable demographics (median age is 17-27 years old).

Since I last covered this ETF, the ETF has increased exposure to markets like Romania and Colombia, which are both attractively valued. It has also reduced exposure to Nigeria (from 7.54% to 3.65%), which is a smart move due to heightened macroeconomic risks in the region. Moreover, markets like Egypt and Pakistan also have the potential to positively impact performance if they bounce back in 2023 or 2024.

Most of the top 10 countries performed poorly in the past five years. Markets like Pakistan, Nigeria, Egypt, and Colombia are contrarian bets, and they have all declined by more than 46% in the past five years. However, all of these markets trade at single-digit PE ratios. Moreover, MSCI Romania has a 7% yield and trades at 4.77x earnings. Investing in off the radar markets like these could be beneficial when frontier market sentiment improves.

Defaults are Concerning

The recent sovereign debt defaults, in markets like Argentina and Sri Lanka, are disturbing, given that they are not historically common. There were 17 sovereign debt defaults between 1999-2015.

However, there have been 14 different sovereign default events since 2020. One of the key risks is that many of these countries have USD denominated debt and public debt has been increasing in many frontier and emerging economies.

Divergence in Performance

While sustained inflation in 2022 harmed many frontier markets, especially net food and oil importers, many emerging markets stand to benefit from higher commodity prices. Frontier and emerging markets provide higher levels of diversification because of this, as equity markets can move based on domestic economic factors.

For example, Saudi Arabian equities outperformed because it benefited from higher oil prices in 2022. At the same time, countries like Egypt and Pakistan that struggled amid higher energy and food prices experienced substantial drawdowns following Covid.

If you have a set view on commodity price movements or other factors it is easy to add new positions based on these views. For example, this ETF lowered its exposure to Nigeria on the back of macroeconomic risks, but still kept exposure to oil exporter Colombia. This decision provides upside if oil prices continue to remain high.

It would be easy to increase exposure to favorable markets by investing in individual ETFs, alongside this ETF, if you want to outperform the MSCI Frontier Markets Index. Countries like Colombia, Peru, Pakistan, Chile, Egypt, and others have ETFs dedicated to these markets.

This ETF will likely outperform the MSCI Frontier Markets Index. It does not have exposure to Iceland and is underweight other markets like Nigeria and Morocco, which may not perform as well. Moreover, it provides exposure to strategic emerging markets that may be overlooked by larger emerging market specific funds. There are not very many ADRs/single country ETFs for these frontier and smaller emerging market countries, so this is a solid ETF to consider. Frontier markets have had poor performance in recent years, but the valuation in select frontier and smaller emerging markets is becoming harder to ignore.

I am waiting for more economic clarity in Q3 2023-Q4 2023 before labeling frontier markets in general a buy. For the time being, I think selective shopping within frontier and smaller emerging markets is the safest bet. Many smaller emerging markets and frontier markets are undervalued.

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