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The imminent closure of the world’s only exchange traded fund physically investing in frontier markets draws a line under an attempt to extend the ETF format into a notoriously illiquid field.
BlackRock said last month that it intended to liquidate its then-$400mn iShares Frontier and Select Emerging Markets ETF (FM) in 2025 due to “persistent liquidity challenges”.
The impending closure will leave the Luxembourg-domiciled $92mn Xtrackers S&P Select Frontier Swap Ucits ETF (DX2Z) as the world’s only remaining frontier equity ETF, according to data from Morningstar Direct. This fund relies on “synthetic” swap-based replication of the underlying index, rather than investing directly in frontier market stocks, as the iShares ETF does.
The demise of FM is part of a wider retreat by the ETF industry from problematic markets, with Global X axing its MSCI Nigeria ETF in March in response to Nigeria’s foreign exchange policies.
In the same month, VanEck announced the liquidation of its Egypt ETF, citing concerns around performance, liquidity and investor interest.
These terminations followed the closure of the Market Access MSCI Emerging and Frontier Africa ex-South Africa Index Ucits ETF and Lyxor Pan Africa Ucits ETF in 2016.
The retreat from funds physically investing in frontier markets is in sharp contrast to the fortunes of the fast-growing ETF industry as a whole, which saw its global assets surge to a record $13.1tn at the end of June in the wake of record first-half inflows, according to ETFGI, a consultancy.
“It becomes very difficult to operate an ETF in a pool of assets where the liquidity is not there. ETFs are only as liquid as their underlying holdings,” said Ben Johnson, head of client solutions, asset management, at Morningstar.
The iShares ETF successfully navigated the frontier waters for nearly 12 years. However, its underlying benchmark, the MSCI Frontier and Emerging Markets Select index, has been progressively denuded by countries being stripped from the index and promoted to emerging market status.
Argentina and Kuwait, once the frontier market’s heavyweight duo, were promoted in 2019 and 2020, respectively (although Argentina has since been demoted to a sub-frontier “standalone” status). The United Arab Emirates and Qatar earned promotion earlier still, while Saudi Arabia completely leapfrogged the frontier rung in 2019 when it went straight from standalone to emerging.
Bulgaria and Ukraine suffered the ignominy of moving in the opposite direction, from frontier to standalone status.
As a result, the MSCI benchmark now consists of 19 frontier markets, headed by the likes of Vietnam, Romania, Nigeria, Kenya, Morocco, Pakistan and Bangladesh, as well as four emerging markets: Colombia, Egypt, Peru and the Philippines.
“You have just got to look at the nature of the investment opportunity set,” said Johnson. “FM has been a fairly large fish in what I wouldn’t even characterise as a pond, and a pond that has evaporated in the past few years with some of the largest countries in that opportunity set graduating to emerging markets and the liquidity in what is left being quite thin.”
Worse still, in recent years funds that have sold stocks in some of these countries have faced difficulties in repatriating the proceeds, as a number of central banks have periodically enacted policies limiting the ability to convert local currency into dollars.
This was most notoriously the case in Nigeria, where for years even importers struggled to access dollars and airlines pulled out of the country due to their inability to repatriate revenues.
Nigeria was “the straw that broke the proverbial camel’s back”, Johnson said.
Charlie Robertson, head of macro policy at FIM Partners, a Dubai-based frontier and emerging market investment house, said FX issues have not been confined to Nigeria.
“I think it was probably the time hours management of it [that led to the decision to liquidate FM]”, he said. “The ETF ideal is a low-touch, low-cost replica of the market and that is impossible when your market is Nigeria or Egypt or Pakistan, where it was difficult, if not impossible, to get your money out.
“It’s something that only active management would make sense of, and they still wouldn’t have got their money out,” Robertson added.
BlackRock attempted to keep the show on the road by converting FM from a passive index-tracking vehicle to an actively managed one, “to react more quickly to macro challenges and filter out some of the financially challenged names in the portfolio”, according to a spokesperson. But even this does not appear to have been enough to save it.
The synthetic approach favoured by Xtrackers — which has a swap contract in place with a counterparty, HSBC, to replicate the performance of the underlying assets — avoids these problems.
However it can have its own issues — investors in the ETF suffered an artificial loss last year when Nigeria was stripped from its index, operated by S&P Dow Jones, at a “zero-price”. Also, the swap transaction cost “can be high”, Xtrackers, concedes.
There are still at least 20 mutual funds globally that invest in frontier markets, according to Morningstar.
Compared to an ETF, which is priced “every millisecond, in real time”, it is easier to manage a mutual fund “pricing at NAV daily”, Johnson added.
Robertson lamented the timing of FM’s closure.
“It’s after they have devalued markedly in Nigeria and the markets have now opened there and elsewhere, and most of these countries have got IMF programmes,” he said. “All the problems have disappeared and at the point where you want to buy the market, the ETF is closing.
“When they close the fund is usually the time they shouldn’t,” he added.
