An Alternative Emerging Market ETF Play

January 18th at 4:26pm by Tom Lydon

Exchange traded funds offer investors the opportunity to gain access to a greater pool of assets. Emerging market securities used to be limited to large institutional investors who had the means to gain exposure to far, out-of-the-way markets. However, ETFs have become the great equalizer, bringing alternative assets to the retail investor. Along with easier access to developing market equities, individuals are now able to tap into emerging market debt with ETFs.

The market for debt in emerging countries has come a long way, developing into a viable asset class that investors can access with relative ease. Apart from the robust growth rates and cleaner balance sheets, many developing economies have improved their economic, legal and regulatory systems, bringing greater stability to their markets.

Emerging market bonds, or fixed-income debt, are issued by developing countries and their domestic companies. Credit quality has improved over the years, but emerging markets are still seen as higher credit risks than their developed counterparts – most investment ratings firms have kept emerging market credit quality at non-investment grade, speculative ratings or lower. Of course, the higher risk also comes with the potential for higher returns. While credit risk and potential defaults are large considerations when choosing bonds from the developing side of the world, emerging economies have dramatically reduced their debt levels to around 50% of their gross domestic product and lower, compared to European and the U.S. which sit at around 100% of debt-to-GDP and Japan at above 200% debt-to-GDP.

Before investing in an emerging market bond ETFs, investors should determine whether or not the bond ETF is dominated in the local currency. Some funds hedge their foreign currency exposure, so investors in these ETFs don’t need to worry about whether the Brazilian real or the Indian rupee is weakening versus the dollar.

Accessing emerging market sovereign debt has traditionally been quite difficult. At one time, retail investors could only gain exposure to emerging market debt through expensive mutual funds, which required hefty minimums. However, the ETF industry has launched a handful of portfolios tracking emerging market bonds, denominated in both the local currency and in U.S. dollars, some of which have already attracted hundreds of millions in assets.

Emerging Market Debt ETFs

Invesco PowerShares and BlackRock’s ETF division, iShares, were the first to introduce emerging market bond funds. The PowerShares Emerging Markets Sovereign Debt Portfolio (NYSEArca: PCY) and the iShares JPMorgan USD Emerging Markets Bond Fund (NYSEArca: EMB) both began trading in 2007. Since both funds track U.S.-denominated emerging market debt, investors should not have to worry about foreign currency risk – the direct affect movements in the forex market may have on the funds’ performance.

EMB tracks the JPMorgan EMBI Global Core Index, which also follows U.S.-denominated emerging market debt. The fund has $3.5 billion in assets, an expense ratio 0.60% and yields around 4.9%. The ETF follows a market-value-weighted strategy, which means that the countries with the most amount of outstanding debt will have a larger weighting within the index, but it does limit weightings at 8%. Top country allocations include Mexico at 7.9%, Brazil at 7.8%, Russia at 7.8%, Turkey at 6.9% and the Philippines at 6.9%.

PCY attempts to reflect the DB Emerging Market USD Liquid Balanced Index, which follows liquid emerging market government bonds that are denominated in U.S. dollars. The fund has $1.4 billion in assets, an expense ratio of 0.50% and yields 5.5%. The ETF is also very well balanced among emerging market countries as it employs an equal-weight strategy. For instance, top country allocations include Columbia at 4.9%, Indonesia 4.8%, Qatar 4.7%, Vietnam 4.2% and Russia 4.2%, to name a few.

WisdomTree and Van Eck launched their own emerging market debt ETFs in 2010. These newer ETFs follow the local currency and investors should be aware that potential foreign currency fluctuations may affect returns – if the foreign currency appreciates relative to the dollar, the funds will be positively influenced by the foreign currency conversion rate.

The WisdomTree Emerging Markets Local Debt Fund (NYSEArca: ELD) is an actively managed ETF that holds a basket of debt denominated in the local currencies of the emerging market countries from where the securities came from. ELD selects bonds from countries based on low debt-to-GDP, large foreign reserves, positive growth and adequate inflation levels, among others. The fund has $1.1 billion in assets, an expense ratio of 0.55% and yields 4.7%. Some of its largest country allocations include Brazil, Mexico, Indonesia and Malaysia.

The Market Vectors Emerging Markets Local Currency Bond ETF (NYSEArca: EMLC) also tries to reflect movements in local currency bonds issued by emerging market governments.  The fund has $509.4 million in assets, an expense ratio of 0.49% and yields 5.8%. Top country allocations include Malaysia 10%, Brazil at 10%, Poland 10%, South Africa 10% and Mexico 10%. The ETF caps holdings at 10% to help limit the influence any single region may have on the overall portfolio.

The iShares Emerging Markets Local Currency Bond (NYSEArca: LEMB) is the latest addition to the asset category. LEMB tries to reflect the Barclays Capital Emerging Markets Broad Local Currency Bond Index, which is a market-value-weighted index that follows the performance of emerging market sovereign debt denominated in their local currencies. The fund has $29.3 million in assets, an expense ratio of 0.60% and provides a yield of 5.6%. Top country allocations include Korea 20.1%, Brazil 14.7%, Mexico 6.9%, Poland 5.3% and Colombia 4.6%. LEMB leans toward emerging markets with more developed and liquid bond markets.

Investors seeking a more narrowly focused emerging market bond ETF may consider the WisdomTree Asia Local Debt Fund (NYSEArca: ALD), which tries to reflect local debt denominated in currencies of Asia Pacific countries, excluding Japan. The fund has $398.5 million in assets, an expense ratio of 0.55% and a yield of 2.2%. Top country allocations include Thailand, Malaysia, Indonesia, Australia and South Korea. ALD is similar to WisdomTree’s Emerging Markets Local Debt ETF ELD, except it only holds bonds from Asia Pacific countries.

Full disclosure: Tom Lydon’s clients hold shares of EMB.

The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.

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