Investors looking to capitalize on the rapid growth of emerging markets may be missing opportunities for better returns—and increased portfolio diversification––by focusing solely on well-known emerging market  funds.

These funds tend to be dominated by major developing countries such as Brazil, Russia, India and China—the BRIC markets—as well as Taiwan and Korea.  While emerging market stocks did well last year—the MSCI Emerging Markets Index was up 15.15 percent in 2012, the index is down 5.48 percent year-to-date. Slow growth in developed markets and the export driven nature of major emerging market economies have weighed down the stocks in these countries.

By contrast, the stocks of smaller emerging markets such as Turkey and Indonesia, as well as so-called frontier markets, have performed well.  Frontier markets are earlier in their capital market development than major emerging markets. “They are what emerging markets were 10 or 15 years ago,” says Alec Young, global equity strategist at S&P Capital IQ in New York.

The MSCI Frontier Markets Index, which includes such countries as Bangladesh, Bulgaria, Croatia, Kuwait, Nigeria, Sri Lanka and Vietnam, is up 6.42 percent year to date. In fact, in the last three years, the BRIC markets have underperformed frontier markets––the Bric markets are down 6.75 percent versus a decline of 2.52 percent for frontier markets during the period. 

“There has been a shift in performance and market leadership is changing,” Young said during a webinar on this topic earlier this week. ”We are recommending increased exposure to smaller emerging and frontier markets.”

Besides better return opportunities, Young said, smaller emerging markets also provide better diversification. As the economies of major emerging markets have become increasingly intertwined with developed markets, their correlation with developed markets has risen. The MSCI Emerging Markets Index has a correlation of 0.82 with the S&P 500 versus 0.55 for the MSCI Frontier Markets Index. Frontier market stocks tend to be more focused on domestic markets, providing investors with more exposure to the expanding consumer sector in those countries.

The fundamentals of frontier markets also are attractive with the MSCI Frontier Markets Index trading at 10 times consensus 2013 earnings estimates versus 10.7 times for MSCI EM and 14 times for the MSCI EAFE Index of international developed markets. 

But while the monthly standard deviation of the MSCI Frontier Markets Index is 20% versus 23.5% for the MSCI Emerging Markets Index, both are higher than the 17.5% standard deviation of MSCI EAFE Index. That higher level of risk is reflected in a fat dividend yield of 4.2% for the frontier market index.

Limited Choices

The problem for investors looking for ETFs that provide exposure to smaller emerging and frontier markets is that the choice is limited. Liquidity issues, restrictions on foreign ownership of stocks, and the relative newness of the asset class make finding funds dedicated to smaller emerging markets a challenge, especially for cost conscious investors. Still, there are options and ways to finesse the issue.

One diversified ETF that does provide exposure to frontier markets directly is the iShares MSCI Frontier 100 Index Fund (FM), which tracks the  MSCI Frontier Markets 100 Index. The fund launched in September 2012 and now has $81.3 million in assets. Its largest country weightings are Kuwait, Qatar and Nigeria.  Financials make up 53.6 percent of the portfolio followed by telecom stocks.

“What we like about FM is the assets inside the portfolio are high quality,” says Todd Rosenbluth, S&P Capital IQ’s director of ETF and mutual fund research. Among the fund’s top 10 holdings are Nigerian Breweries Plc and Qatar National Bank, both of which have consistently raised dividends and increased earnings, Rosenbluth notes.

The fund is up 6.44 percent year to date and has returned 15.0 percent since inception. Its expense ratio is 0.79 percent, which is higher than its parent company’s popular iShares MSCI Emerging Markets Index Fund (EEM), which costs 0.69%.

An alternative is to invest in emerging market funds that add exposure to small- and mid-cap stocks, which tend to be more domestically oriented, Rosenbluth says. He highlights the iShares Core MSCI Emerging Markets ETF (IEMG). This ETF, which was launched in October 2012 and already has $920.7 million in assets, has 21 percent in small- and mid-cap stocks versus 13 percent in these stocks for EEM.

The fund is down 6.13 percent year to date, slightly better than the negative 7.45 percent return for EEM. “It’s doing slightly better because of its mid- and small-cap exposure,” Rosenbluth says.