Finra turns its ever-watchful eye on frontier funds

The Financial Industry Regulatory Authority plans to pay special attention to frontier markets mutual funds and exchange-traded funds in examinations of broker-dealers this year after concerns were raised that the risks of such funds are not being adequately disclosed to retail investors.

“Heightened risks associated with investing in foreign or emerging markets generally are magnified in frontier markets,” Finra wrote in a letter posted on its website Thursday in which it detailed its 2014 examination priorities.

“Many frontier markets operate in politically unstable regions of the world and are subject to potentially serious geopolitical risks,” it continued. “In many cases, these markets have relatively few companies and investment opportunities, and the local securities market may not be fully developed. This could mean less liquidity and lower investor protection standards.”

Indeed, the biggest concern with frontier market stocks is investors’ access to their capital. Since most of the local stock markets are in the early stages of development, none of the issues are particularly liquid. That didn’t cause a problem last year, when a net $1.8 billion flowed into the funds and pushed prices up, but if that trend reverses, the stocks could be in for a big fall.

“Frontier markets are, needless to say, a little arcane,” said Andrew Clark, an alternative investment research analyst at Lipper Inc. “People definitely know about emerging markets, but how many people are thinking about Nigeria or Uzbekistan?”

Frontier mutual funds invest in countries that are less developed than emerging markets, typically those in Africa or the Middle East. They’ve been dubbed by some as the “next” emerging markets since they have the same potential for growth of a middle class of citizens as emerging markets, such has the BRIC countries, but are far behind on the development curve.

As yet, frontier markets are a relatively small niche among mutual funds and ETFs.

There are fewer than a dozen available today, with less than $3.5 billion in assets combined. For comparison, diversified-emerging-markets mutual funds have more than $277 billion in assets.

But as far as performance goes, they have been on a tear versus emerging-markets funds.

The $432 million iShares MSCI Frontier 100 ETF (FM) was up 20% in 2013, while the $39 billion iShares MSCI Emerging Markets ETF (EEM) lost 3.7%.

The $1.5 billion Templeton Frontier Markets Fund (TFMAX), the largest frontier markets mutual fund, gained 16% in 2013 and the $936 million Wasatch Frontier Emerging Small Countries Fund (WAFMX) was up 18%. The average diversified-emerging-markets fund was flat in 2013, according to Morningstar Inc.