Invest in the Middle East -- but Not With Oil

Two new frontier-market funds have come out recently -- the WisdomTree Middle East Dividend Fund (GULF) and the Market Vectors Gulf States Index ETF (MES). Like the PowerShares MENA Frontier Markets Fund (PMNA), they obviously focus on the Middle East.

What's more, they could be right for your portfolio, if you take the time to figure out which of them works best for you.

The frontier segment is becoming more important, as opposed to the emerging-market segment, because these frontier countries are building their economies, and funds such as these can be useful for portfolio diversification. The correlation for most emerging markets to the U.S. has gone up in recent years, as U.S.-based investors have flooded that segment, but frontier-segment countries continue to have little correlation.

To make matters even better, the frontier space is becoming more accessible -- and anyone interested in the space should look at all the choices, decide whether any exposure is appropriate, and then try to choose the fund that makes the most sense to them.

The differentiator for the dividend fund from WisdomTree is that it weights the holdings by dividends paid. MES stands out for being more narrowly focused on just the Gulf Cooperation Council states weighted by market cap, and it excludes Egypt and Morocco, which both weigh prominently in the other funds.

Beyond those structural differences, the funds take divergent paths at the country and sector level. MES invests in only five countries: Kuwait 52%, U.A.E. 25%, Qatar 15%, and then much smaller weights for Oman and Bahrain. GULF favors Kuwait, but only at 25% of the fund, followed by U.A.E. 20%, Qatar 15%, Egypt 11%, Morocco 9% and, again, much smaller weights in Jordan, Oman and Bahrain.

Just like with PMNA, the financial sector is the largest for both funds, 47% for GULF and 60% for MES, and energy has almost no weighting. That might seem like a surprise, but the oil companies in this part of the world are run by the respective governments.

Telecom is featured prominently in GULF, with a 24% weight, but only 3.6% in MES. Both funds allocate about 7% to materials, GULF has 5% in real estate compared with 10% for MES, MES found 7% for technology compared with none for GULF, and neither fund really captures consumer stocks in any meaningful way.

One interesting item about the stock selection is that while MES has no weighting in Morocco, GULF's largest holding is Maroc Telecom, the big phone company from Morocco that composes 9% of the fund.

In addition to composition differences, there are also big differences in the back tests. GULF's back-test had one-year and three-year returns of 37.79% and 26.71% annualized, compared with 28.81% and 10.17% annualized for MES.

It isn't clear if the GULF back test is superior because of the large weight to Maroc Telecom, the allocation to Egypt, the reinvestment of dividends or something else. To the extent that dividends helped, one thing to keep in mind (using the other WisdomTree funds as examples) is that GULF's yield might be noticeably less than the 5.31% noted on the WisdomTree site.

If a lot of assets pour into the fund, the actual payout should be expected to be less than the index until growth of the fund moderates.

As I mentioned in my recent article about PMNA, the back-test probably is not that important.

I believe the decision about which one is likely to outperform will boil down to whether or not the GCC states will continue to their path to being more relevant to the world economic order. If so, I would expect MES to be the better choice.

The weights to Egypt and Morocco will either be a drag in that light or will help GULF outperform, in case investing in the GCC countries turns out not to be a one-way trade.

The Middle East not being a one-way trade is something to weigh carefully. In the first half of 2006, most of the region endured a 50% correction. Currently, most of the region is dealing with high and increasing rates of inflation. The asset class -- frontier markets -- is viable, but any allocation should be moderate.

At the time of publication, Nusbaum held no positions in any of the investments mentioned, 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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