Until today, frontier markets were probably the hottest investments that investors couldn't get at. Ever-hungry for diversification as developed markets begin to correlate more closely with each other, investors began to cast covetous eyes upon some of the world's smallest markets some time ago, but there were very few ways to access them easily.

Now Claymore Securities has burst onto the scene with the first U.S.-listed exchange-traded fund to cover frontier markets. The Claymore/BNY Mellon Frontier Markets ETF (FRN) tracks an index from Bank of New York that currently includes 42 ADRs from 15 different countries.

"These frontier markets are 10 years behind where Brazil, Russia, India and China are. These are tomorrow's most intriguing growth opportunities," said Claymore Securities President Christian Magoon, noting that the firm had launched the first "BRIC" ETF when it launched its first ETFs about 18 months ago. The Claymore/BNY BRIC ETF (AMEX: EEB) currently has about $1.2 billion in assets and is up more than 115% from its inception, according to Magoon.

"We wanted to get in front of the growth projected for those countries and launch the first frontier market ETF," he explained. "Similar to our solar ETF, it was only recently that enough companies with large enough market caps existed to create an investable frontier market ETF."

The Index

Given the success of EEB, it is not surprising that Claymore has gone back to the well in terms of the index provider.

"We wanted to partner with an index provider that had expertise in these markets and had the broadest index available," he said.

The index includes only depositary receipts—ADRs or GDRs—which are companies listed on U.S. or other major developed market exchanges. Magoon noted that Bank of New York Mellon is responsible for 64% of the world's depositary receipts.

"There's certain due diligence and qualifications you have to meet as a company to have a depositary receipt. We think that given the volatility of frontier markets, having that extra process in place is a more conservative approach to investing in frontier markets but also a more effective approach," Magoon said.

BNY evaluated countries on an individual basis on five criteria—GDP growth, experienced and expected inflation, per capita income growth, privatization of infrastructure and social inequalities—and came up with 41 countries that fit its definition of what a frontier market is. Individual stocks in those 41 countries were screened according to liquidity, which was a primary concern, according to Magoon, and certainly one of the key concerns of investors delving into nondeveloped markets. The BNY methodology required companies to meet minimum volume requirements as well as have a minimum market capitalization of $100 million and a minimum share prices of $3. Once those screens were applied, however, only companies from 15 countries were eligible for inclusion. BNY will re-evaluate the universe on a quarterly basis.

BNY's definition of what constitutes "frontier" aside, several of the countries represented in the index actually qualify as emerging markets by the standards of some of the major index providers, although there is no cut-and-dried definition of what the difference is between the frontier and emerging designation. In particular, the three largest countries—Poland, Chile and Egypt—are classified as emerging by Dow Jones Indexes, MSCI Barra, Standard & Poor's and FTSE; together, those three countries represent almost 64% of the index. Eight of the top 10 components in the index are from one of these three countries. Other countries with emerging market status in the index include Peru, the Czech Republic, Pakistan and Colombia.

The countries that do not make it into the emerging markets indexes of all of the major global index providers include Kazakhstan, Lebanon, Nigeria, Oman, Croatia, Bahrain, Georgia and the United Arab Emirates; together they amount to nearly 21% of the index's total market capitalization. In what seems like a glaring omission, Vietnam, a darling of frontier market fans that has experienced rather stunning growth, is not included in the index. It apparently did not meet the screening criteria.

Not surprisingly, the index is heavily weighted toward Financials, which weigh in at 37.27%, followed by Telecommunications at 16.24% and Materials at 13.46%. In all, the index has a total market capitalization of more than $110 billion.

FRN charges 65 basis points and is listed on the NYSE Arca.

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