Emerging Market Local Debt ETFs Ripen

March 23, 2016

Diversification Refresher

With the S&P 500 performing so strong over the last few years, we saw many investors vilifying positions in their portfolios that had trailed. The unique economic environment particularly suited U.S. large-cap stocks. However, it was unfavorable to many other investments.

Recent markets provide us the opportunity to reflect and remind investors of why they diversified in the first place.

Remember one of the key tenets of diversification: Investors should expect some things to be down when others are up, and vice versa. If everything in a portfolio is up in a given market environment, there may be a higher risk of everything going down in tandem in an alternate market environment.

In 2015, large-cap growth stocks and EM debt were the winners and losers, respectively. In 2016, it has been the opposite so far, with EM debt outperforming large-cap growth stocks by more than 8%.

Strong Rally YTD

When something reaches its breaking point, it either breaks or it doesn’t. Given economic and stock market results in 2015, it seems to us that some investors thought EMs would break completely. This would involve real countries with real people hanging up the towel and closing up shop.

We have reminded investors that, unless you feel like roughly 80% of the world’s population who lives in emerging markets (according to the European Central Bank) is hanging up the towel tomorrow, you should maintain appropriate strategic exposure to emerging markets.

Performance of EM stocks and bonds in 2015 reminds us of when the Dow hit 6500. The pessimism meter had hit its limit. However, 320 million people in the U.S. decided they would still get up and go to work, buy stuff and have babies who need to eat. EM countries are making some of those same responsible choices, even though valuations seem to portend investors instead expected an emerging market mass suicide.

Investors who have stuck with EM stocks and bonds benefited in 2016 so far. The MSCI EM Currency Index is up nearly 6%, since its Jan. 20 low. Likewise, EM stocks are up more than 20%, and EM local debt is up more than 12% since Jan. 21.

Source: Bloomberg

The Look Forward

Local-currency EM sovereign debt has had a difficult run the last few years. As EMs have battled slowing global growth, falling commodity prices and an astronomical rise in value for the U.S. dollar, emerging market sovereign debt has fallen in dollar terms.

However, many top investors think the view through the window is brighter. In reviewing expected returns from PIMCO, William Blair, Eaton Vance and GMO, we have found that all four expect EM local debt to perform strongly in the next five to 10 years.

While some investors feel opportunity exists, we have concern about the credit risk of dollar-denominated EM corporate debt. Investing in these bonds requires investors to factor in significantly more credit risk than sovereign debt. Likewise, we recognize currencies are incredibly difficult to predict, and the path of the U.S. dollar will have a significant impact on local currency EM positions.

However, if you feel currency will cycle and normalize over time, EM local sovereign debt may be a viable asset class to include in a well-diversified portfolio. While we suggest only moderate exposure, we feel sophisticated investors should recognize EM debt as a viable tool in the toolbox.

EM debt is has a nearly 6% SEC yield, as opposed to less than a 2% yield on the 10-year U.S. Treasury. It is unlikely the U.S. dollar will appreciate another 16% over the next three years versus EM currencies. Likewise, the longer-term trend of increasing credit quality in EM sovereign debt has not shifted. If these trends continue, it could bode well for local-currency sovereign EM debt.

ELD, EMB and EMCB have been, may be and/or are currently held in several TOPS Portfolios. ValMark Advisers Inc. is the manager of the TOPS Portfolios of ETFs. ValMark started managing "TOPS" separately managed accounts of ETFs in 2002. The firm manages more than $5.1 billion in ETFs for retail and institutional clients in multiple investment products. Email: [email protected]; phone: 800-765-5201. For a complete list of relevant disclosures, please click here.

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