Frontier Market Index Secrets Revealed

Most passively managed ETFs are designed to track underlying indices and most ETF investors know that. How much time investors spend studying the index an ETF tracks is another matter altogether.

Aside from knowing that Procter & Gamble PG is the largest stock in many staples indices and that same can be said of Exxon Mobil XOM in energy indices, index construction is a seemingly unapproachable topic for some.

Index constitution and construction may not give everyone the warm fuzzies, but it is a vital component of successful ETF investing, particularly in foreign markets. That includes frontier markets, which have soared to prominence this year as investors have sought alternatives to disappointing emerging economies.

Related: Frontier Markets ETFs Cheap, Too.

MSCI's MSCI Sebastien Lieblich, the firm's executive director of index research, revealed to Benzinga in a recent interview exactly how the MSCI Frontier Markets Index, which is not the underlying index for the $257 million iShares MSCI Frontier 100 ETF FM, was built and what the index will look like in the future following some important changes.

There are, of course, complexities involved in building an investable frontier markets index, including clients' liquidity concerns and ensuring candidate countries even have enough viable options in terms of companies to be possibly included in the index.

"Even in the frontier space, we try to construct indices that are investable," said Lieblich. "Some markets don't meet our liquidity standards. Each country must have at least two companies to be included in the index."

For now, the MSCI Frontier Markets Index is heavily skewed toward the Middle East, a scenario that Liebtich says is "a reflection of the frontier markets opportunity set."

For FM, the frontier ETF, that means Kuwait, Qatar and the United Arab Emirates dominate the fund. Those countries combine for roughly 59 percent of FM's weight. FM will not look that way forever. In fact, the ETF will only look that way until the second quarter of next year because MSCI earlier this year announced Qatar and UAE have been promoted to emerging markets status.

When Qatar and UAE depart for the MSCI Emerging Markets next year, Kuwait alone will be 30 percent of the frontier index's weight with another 20 percent going to Nigeria, Africa's second-largest economy.

Lieblich notes it is "not a subjective decision by MSCI to weight Kuwait at 30 percent," but rather "the result of market structure."

Morocco, Pakistan and Kenya will round out the top-five country weights in the frontier index. Morocco was recently demoted by MSCI from emerging markets status. Pakistan and Kenya currently combine for about nine percent of FM's weight.

Other Markets
While Qatar and UAE have attracted the bulk of the attention among investable frontier markets this year, some investors have become acquainted with other frontier markets over the years, including Argentina and Vietnam.

Those markets are directly accessible through the Global X FTSE Argentina 20 ETF ARGT and the Market Vectors Vietnam ETF VNM. Vietnam has been the more popular of the two as highlighted by VNM's $358.8 million in assets under management. While Vietnam is in a region chock full of markets investors have previously embraced, such as Indonesia, Malaysia and the Philippines, the market presents its own complexities to investors.

Those include foreign ownership limits, something the government is working to improve. Still, those foreign ownership cap Vietnam's weight in the MSCI Frontier Markets Index.

"Vietnam applies stringent foreign ownership limits," said Liebich. "So the available investable universe for foreign investors is smaller in Vietnam than, say, in Pakistan. If the foreign ownership limits are reversed, it could lead to increased weights for Vietnam in the future."

As for Argentina, once South America's second-largest economy, the country was demoted by MSCI to frontier from emerging status over four years ago. The country accounts for 3.9 percent of FM's weight.

"Argentina was reclassified entirely due to capital controls implemented by the government that hurt foreign investors," said Lieblich. "It was really a situation specific to Argentina, not other markets."

Below frontier status is "stand alone," a group that, according to MSCI's classification methodology, has six countries. Those are Botswana, Ghana, Jamaica, Palestine, Trinidad & Tobago and Zimbabwe. Adventurous investors will like to know that Lieblich said only one of those six has a somewhat reasonable chance of being added to the frontier markets index anytime soon and the second place country on the list is well behind the first for possible inclusion in the MSCI Frontier Markets Index.

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