Middle East Fund Has Its Quirks, Perks

Just last month, the news was about Claymore BNY/Mellon Frontier Markets ETF (FRN) -- and now, we have the second-to-market PowerShares MENA Frontier Countries Portfolio (PMNA), which will mimic the NASDAQ/OMX Middle East North Africa Index.

FRN is diversified across several types of frontier markets, but the index underlying PMNA only invests, as the name implies, in a very narrow region; Kuwait 19.74%, UAE 19.04%, Egypt 16.11%, Qatar 14.52%, Morocco 12.21%, Jordan 9.20%, Oman 4.77%, Lebanon 2.22% and Bahrain 2.21%.

This is a regional fund, so country weights are large because the region doesn't have too many investible countries. If the region makes sense for your portfolio and you don't want to pick stocks, the regional approach is as broad as it's going to get.

The sector allocation may be a bit of surprise, only 2.41% of the fund is energy. The big oil companies from these countries are owned by the respective governments and not listed on the local exchanges.

The biggest sector by far is financials, at 56.07%. Telecom is second at 16.52%, industrials at 15.35%. The rest are too small to move the needle. The weighting in financials leaves me wanting to learn about Middle Eastern banks. But, the index does not concentrate the stocks held, with only three names being larger than 5% (and not much larger than 5%, at that).

The fund may seem expensive at 0.95%, but accessing any sort of frontier or lower emerging market is not going to be cheap.

There are a couple of structural elements that complicate things a bit.

1) One beneficial aspect of owning ETFs is the tax efficiency, most of the time there are no capital gains distributions. This occurs because of something in the day to day running of ETFs called in-kind transfer. The practice of in-kind transfer will not exist with PMNA, which creates the visibility for capital gains to be paid to shareholders which are taxable depending on the type of account that the fund is held in.

2) One other quirk: Although it will be temporary, the fund, as opposed to the index, will not own the Kuwaiti stocks but instead will own a type of note called a Participation-note that will serve as a proxy for the intended Kuwaiti exposure. The fate of the Participation-note is dependent on the fate of the issuer ( Deutsche Bank ( DB), Citicorp ( T) and Morgan Stanley ( MS)). A failure is unlikely, but were a failure to occur, the fund would be negatively impacted.

The P-notes will be swapped out for Kuwaiti equities once PowerShares completes the process for opening an account in Kuwait to buy and sell securities and at this time there is no timeline of when that will occur.

As for the normal sorts of risk, like market fluctuation, there is some recent history to understand. Most of the region skyrocketed in 2005. Egypt, for example, was up 100% but then in the first six months of 2006 the region got decimated. Egypt was down almost 40% and the index underlying the fund was down 28%.

Since that correction in 2006, the region has again skyrocketed. Egypt is down 20% since mid-May. Kuwait rallied 30% from early December through late June and is down only 3% from its peak. Given what is going on in the world equity markets, it makes sense to wonder whether Kuwait turns out to be an exception or simply hasn't gone down yet.

The long-term potential benefit to the frontier asset class is that it tends to be less volatile than emerging markets and has a low correlation to emerging markets, yet delivers a similar return as emerging markets.

As for a verdict on the fund, I will be more favorably disposed once the P-note issue has been resolved. Clearly the region is compelling, it makes intuitive sense that the GCC countries will continue to be increasingly more relevant to the global economic order which stands to mean good things for the stock markets there.

One last word of caution: Despite the data about volatility available on the PowerShares site and elsewhere about frontier markets, recent history suggests that there will be a lot of volatility along the way.

At the time of publication, Nusbaum has no positions in any of the named securities, although positions may change at any time.

Roger Nusbaum is a portfolio manager with Your Source Financial of Phoenix, and the author of Random Roger's Big Picture Blog. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Nusbaum appreciates your feedback; click here to send him an email.

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