Emerging Markets Debt ETFs

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Friday’s Wall Street Journal noted that investors snapped up bonds issued in Russia, Mexico and even Kazakhstan.

ETF investors looking to join in have five well-established emerging markets bond ETFs to choose from. By “well-established,” I mean funds with more than $100 million in assets and at least a one-year history.

Beyond the usual credit risk and maturity-related choices that come with picking a fixed-income fund, these five funds raise an additional thorny issue:currency exposure.

Those new to the space might expect the bonds inside the ETF to be issued in the local currencies.

Many are, but the top two funds take a different tack. The JPMorgan USD Emerging Markets Bond ETF (EMB) and the PowerShares Emerging Markets Sovereign Debt Portfolio (PCY) hold emerging markets bonds issued in U.S. dollars.

To be clear, these funds aren’t hedging their currency risk as some equity funds do, but instead hold debt issued in dollars instead of say, Brazilian reals or Mexican pesos. This selection process shields U.S. investors from direct currency exposure.

However, if an issuing country suffers massive inflation, servicing U.S.-dollar-denominated debt could be difficult, so in extreme cases, the risk is merely shifted—from currency risk to default risk—rather than avoided.

Still, the currency impact on returns can’t be overstated:U.S. investors were pummeled over the past year by the relative strength of the dollar against emerging markets currencies.

The emerging markets currency impact was -9.19 percent over the past 12 months, with Latin American emerging markets currency exposure particularly painful, at -18.06 percent, according to our Currency Impact Report .

Over the past 12 months, currency impact separated the returns of the five funds clearly along the lines of the dollar-denominated bond funds versus those with locally denominated holdings.

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EM Bonds - 1 year

EMB and PCY—the two dollar-denominated funds, outperformed their locally denominated peers by double digits. They are shown above in light blue and dark blue, respectively. Performance numbers are spelled out in the table below.

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Emerging Market Debt

 

Over the past 12 months, the currency effect has played a much larger role than other aspects of each fund’s portfolio.

Four of the five funds focus on sovereign debt:EMB and PCY, as well as two local-currency funds:the Market Vectors Emerging Markets Local Currency Bond ETF (EMLC) and the SPDR Barclays Capital Emerging Markets Local Bond ETF (EBND).

The WisdomTree Emerging Markets Local Debt ETF (ELD) is the only actively managed fund in the top five, and its managers have a longer leash in terms of security selection.

They can actively select sovereign or corporate issues that span a credit spectrum from junk to investment-grade bonds. ELD is constrained to local currency bonds however, so its recent returns closely align with EMLC and EBND, despite the differences in breadth and management.

Expense ratios for the five funds range across a relatively narrow band, from 49 bps to 60 bps. This keeps the focus where it belongs:on the fund’s basket, not its fees. Investors in EMLC will find little comfort in paying 1 basis point less than top-performing PCY.

When the pendulum swings in the other direction and emerging markets currencies start appreciating again, the local currency funds will have their day in the sun.

Until then, investors can effectively take a stand on whether that day is near or far when they choose an emerging markets debt ETF.

 

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