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Index Providers Turn to the Wild Frontier

Demand for emerging market funds has been a bright spot this year.

Through first nine months of 2010, nearly $30 billion flowed in to emerging markets stock and bond funds. By comparison, $50 billion flowed out of domestic large-cap stock funds, according to Morningstar.

These inflows have been inspiring index providers and fund companies to keep pace with exotic offerings that span the far reaches of the globe-even into less developed, frontier markets in Asia, Latin America and Africa.

"Traditionally, emerging markets were shunned by all except by those with the biggest appetite for risk," said Alka Banerjee, vice president of index services at Standard & Poor's, and one of the presenters at Information Management Network's "Super Bowl of Indexing" conference this week in Phoenix.

Emerging markets have been hampered by political risks and structural market deficiencies, including difficulty with custody and settlement, foreign exchange and liquidity, Banerjee said.

"However, the emerging market boom of the last few years has resulted in some improvement in trading infrastructure," Banerjee said.

"There's definitely been an increased interest in emerging market and frontier markets," said Michael Rawson, an exchange-traded fund analyst with Morningstar. "Those areas of the world are experiencing better growth than developed markets and have delivered strong returns over the past 10 years." Investors expect emerging markets "to have good economic growth in the years ahead due to the relatively slower growth in the U.S. and other developed markets, faster population growth and weakening of the dollar due to quantitative easing," he said.

In 2009, emerging markets equities rose 75% on average, beating the Standard & Poor's 500 's 23% increase by far. In 2010, through September, the MSCI Emerging Markets Index is up 10.75%, while the S&P 500 gained 3.89%.

Because of these strong returns, structural improvements in their markets and investors' slowly improved risk appetite following the credit crisis of 2008, Banerjee said, investors are now looking beyond investing for the short term in the largest emerging markets "blue chip" stocks to finding a broad and diverse set of small-cap stocks in the smaller emerging markets and larger frontier markets.

"As investors' comfort level with emerging markets has gone up, frontier markets have become the logical place to search for alpha," Banerjee said.

"This is an allocation that is here to stay and that investors are making for the long term," she said.

To meet this demand, S&P recently launched the S&P BRICT Index, covering Brazil, Russia, India, China and Turkey, rounding out S&P's growing stable of emerging markets indexes covering such markets as Gulf Council Corporation states, Sri Lanka, Pakistan and Africa.

Likewise, in early October, Russell announced the new Russell Frontier Index Series, which will initially include 683 stocks from 41 countries, none of which are represented in the Russell Emerging Markets Index or the Russell Developed Index. The first three indexes will be the Russell Frontier Large-Cap Index, the Russell Frontier Small Cap Index and the Russell Frontier Gulf Cooperation Council Index.

The latter index will be just the first of many focused on the Gulf, since Russell has also just signed an agreement with the Saudi Stock Exchange, known as Tadawul, which accounts for half of the entire equity market capitalization of all GCC stock exchanges.

Russell will create indexes that measure the Saudi and regional Gulf indexes, from which asset management companies can create mutual funds, exchange-traded funds and other financial products.

The reason for the interest in frontier markets, said Steve Wood, a chief market strategist for Russell, is because emerging markets are beginning to move in correlation with developed markets.

This is making "portfolio management and diversification more challenging. Investors want to be able to identify and verify the relationships between different asset classes and opportunities."

Northern Trust Global Investments recently launched the Northern Trust Frontier Markets Index Fund for institutional investors. The fund offers exposure to underrepresented regions such as Eastern Europe, Africa and the Middle East, and is benchmarked to the S&P Frontier Extended 150 Index.

"Sophisticated institutional investors understand the need for diversified international and emerging markets exposure," said CTGI Chief Investment Officer Bob Browne. "Our new index fund offers investors the opportunity to expand their asset allocation beyond developed and emerging markets to the next frontier of capital investment in a highly disciplined and risk-managed framework."

Van Eck Global has just developed the Market Vectors Emerging Markets Local Currency Bond ETF, an ETF tied to a basket of emerging markets bonds issued in local currencies. It tracks the J.P. Morgan Government Bond Index-Emerging Markets Global Core Index. Countries represented in the index include Brazil, Russia, Africa, South Africa, Colombia, Egypt and Turkey.

"Over the last few years, emerging markets have demonstrated resilience as much of the developed world has experienced massive fiscal deterioration and skyrocketing debt levels," said Joyce Chang, J.P. Morgan's head of global emerging markets and credit research.

This new emerging market bond ETF joins a handful of other emerging market debt ETFs, including the newly launched WisdomTree Emerging Markets Local Debt Fund, Powershares Emerging Markets Sovereign Debt Portfolio and the iShares JPMorgan USD Emerging Markets Bond Fund.

"We believe emerging market debt is an attractive asset class, based on the faster growth and typically higher yields available in these countries relative to the U.S. and developed world," said Bruce Lavine, WisdomTree president & COO.

The WisdomTree Emerging Markets Sovereign Debt Fund "will offer full exposure to local currencies, a feature we consider important for many investors because of the potential lower correlations and currency appreciation against the U.S. dollar," Lavine said.

The biggest appeal of emerging markets is their tremendous growth potential, compared to developed nations.

These nations generally have limited debt to outside sources, higher economic growth prospects than developed nations and more profitable publicly traded companies, according to a report from Invesco PowerShares.