Frontier ETF Will Roar Again

03/30/2011 2:43 pm EST

Focus: ETFS

Benjamin Shepherd

Analyst, Breakthrough Tech Profits, Global Income Edge and Personal Finance

Despite investors’ recent preference for US stocks, commodity-rich Latin America is a much safer harbor from inflation, writes Benjamin Shepherd in Personal Finance.

As protests and revolutions continue to roil the Middle East and North Africa, frontier markets have suffered losses amid concerns that the civil unrest could spread.

According to fund flow data from Lipper, US equities have been the destination of choice—February marked the 14th consecutive month of inflows to domestic equity funds. Renewed concerns about European sovereign debt also contributed to this shift.

The SPDR S&P 500 Index (SPY) has gained 5.7% percent so far in 2011, vs. 1.2% for Vanguard Emerging Markets (VWO)—an excellent proxy for the emerging-markets universe. Guggenheim Frontier Markets (FRN) has been the clear laggard, giving up 9.4% year-to-date.

This selloff is overdone for several reasons. For one, the recent political instability should be confined to the Arab world, home to many of the world’s worst authoritarian regimes.

The region is also more susceptible to price inflation because of its reliance on imported foodstuffs. Higher consumer prices and elevated levels of youth unemployment were the flames that ignited the powder keg of disenfranchisement.

Although Guggenheim Frontier Markets maintains an almost 13% allocation to Egypt, South American equities account for 60% of the fund’s investable assets—by far its largest regional exposure. Chilean stocks are particularly well-represented, making up one-third of the portfolio.

Chile offers one of the most attractive growth stories in South America. But it had also become one of the continent’s most expensive markets; its benchmark index traded at more than 21 times earnings as recently as October.

However, concerns about inflation have prompted investors to shift their money elsewhere, reducing the Chilean market’s valuation to about 17 times earnings—not bargain territory, but still the lowest multiple in more than two years.

Similar situations have unfolded in many frontier markets, providing savvy investors with a compelling buying opportunity.

Many of the regions favored by Guggenheim Frontier Markets are home to resource-rich nations that conduct a brisk international trade. These countries are sitting on sizable foreign-exchange reserves that better position them to absorb higher commodity prices. Most of these countries also pursue more rational fiscal and monetary policies than the US.

In short, these nations can tackle inflationary pressures much more aggressively than the US, where high unemployment and subpar growth remain a major challenge.

And although much of the European Union is on relatively sound economic footing, the European Central Bank isn’t in a position to tamp down inflation through interest-rate hikes.

Once the market comes to grips with these realities, assets will flow into the frontier markets. The Guggenheim Frontier Markets ETF rates a buy for investors looking to get ahead of this trend.

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