Frontier Market ETFs Cheap, Too

It has been a favorite battle cry of the most ardent emerging markets bulls: Developing world equities are inexpensive based on valuation.

As these stocks and the corresponding ETFs have stumbled mightily this year, there has been a growing chorus of those highlighting supposedly compelling valuations throughout the developing world.

Despite the calls that plenty of emerging markets are cheap, it has taken months for some ETFs to respond. The iShares MSCI South Korea ETF EWY had to plunge into bear market territory before investors embraced the notion that South Korean stocks were too cheap to ignore.

Only in the past month have Russia ETFs such as the Market Vectors Russia ETF RSX rallied after stocks there lived up to their billing as deeply discounted to the broader emerging markets universe.

Chinese stocks have been cheap for over a year, but only recently have China ETFs been showing signs of life. The good news for investors is that, if they are willing to take the risk, there are some compelling valuations to be had in frontier markets, too. Yes, the very same frontier markets that have outperformed emerging markets for most of this year. Frontier markets have also been resilient compared to their emerging peers.

"Frontier markets have been remarkably resilient to the EM travails. The MSCI Frontier Markets 100 Index is up approximately 15% year to date in dollar-terms. While frontier markets did get hit during the June sell-off, their pull back – of around 10% – was much shallower than that of EM and their subsequent rebound has been much stronger," said iShares Global Chief Investment Strategist Russ Koesterich in a note.

That assessment is true. The iShares MSCI Frontier 100 ETF FM is up 15.5 percent year-to-date compared to a 9.4 percent loss for the iShares MSCI Emerging Markets Index Fund EEM. Even in the past month as emerging markets have rebounded, FM has outpaced EEM by about 125 basis points.

"Despite the strong performance, frontier markets still look relatively cheap," said Koesterich. "The price-to-book ratio of the MSCI Frontier Markets 100 index is currently around 1.3, below the roughly 1.5 of the comparable EM index."

FM currently has a P/E ratio of 15.65 compared to 18.15 for EEM, according to iShares data. The iShares MSCI Brazil Capped ETF EWZ has a P/E of 19.5.

Frontier markets also offer decent yields. For example, FM currently has a 30-day SEC yield of 3.93 percent. The WisdomTree Middle East Dividend Fund GULF has a 30-day SEC yield of 5.33 percent.

Both ETFs were affected by index provider MSCI's MSCI recent announcement that Qatar and the United Arab Emirates will be promoted to emerging markets status next year. That means the two countries, currently a third of FM's weight, will leave that ETF. The two combine for 57 percent of GULF's weight, meaning that ETF will be decidedly more emerging than frontier market in the second quarter of next year.

Regardless of market classification, FM, at least for now, and GULF hold some allure as dividend options. At the end of May, the respective dividend streams for Qatari and UAE firms in the WisdomTree Middle East Dividend Index, GULF's underlying index, were almost $5.3 billion and over $2.6 billion.

Despite the significant run-up this year in Dubai and Qatari stocks, GULF is not richly valued. The ETF's index had a P/E of 11.3 and a price-to-book ratio of 1.52 at the end of the first quarter, according to WisdomTree data.

Something else to consider, particularly with regards to FM. Some frontier markets are high oil plays. Three of FM's top-four country weights are members of the Organization of Petroleum Exporting Countries. Kuwait, Qatar and Nigeria combine for 58.3 percent of the ETF's weight.

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