Emerging Market Local Debt ETFs Ripen

March 23, 2016

This article is part of a regular series of thought leadership pieces from some of the more influential ETF asset managers in the money management industry. Today's article is by Michael McClary, chief investment officer of Akron, Ohio-based ValMark Advisers, which markets the “TOPS” brand of asset allocation models.

Tiger Woods made a splash in the golf community years ago when he started hitting greenside shots with his 3-wood. When faced with certain green-side shots, using a 3-wood (or hybrid club) in a putting motion can give the ball enough lift to carry longer grass and project it toward the hole.

In the era of space age golf-club design, technology often rivals that used by NASA. Some companies have even collaborated directly with NASA contractors on club design.

With so much work going into designing a 3-wood specifically to provide lift to carry a ball more than 200 yards, why are some golfers using it to hit putterlike shots of five to 20 yards?

The answer is that it might be the optimal club for the shot and may lead to the best overall score.

Prioritizing Risk
We often encounter portfolios that are a collection of underlying positions chosen at face value: utility stocks chosen for income, Treasurys chosen for safety of principal and little attention paid to how these individual decisions might impact overall portfolio metrics. Likewise, we often see investors surprised when a position significantly underperforms their expectations due to a risk they hadn’t prioritized.

We feel investors may benefit from looking at investing in emerging market local debt like chipping with their 3-wood. Pay attention to the full spectrum of attributes in EM debt—not just the obvious—and focus on how it interacts with other positions to impact your overall score.

ETFs Give Investors More Choices
As ETFs have grown in size and number, investors have been given the opportunity to invest in areas of the market they may not have invested in 20 years ago. While many mutual funds have invested in EM debt for many years, it was not until the last six or seven years when investors had the ability to take the reins and easily pinpoint their EM debt exposure.

For example. now, investors can choose from investing in EM local debt: the WisdomTree Emerging Markets Local Debt Fund (ELD | C); dollar-denominated EM debt—the iShares J.P. Morgan USD Emerging Markets Bond ETF (EMB | B-58); and EM corporate debt—the WisdomTree Emerging Markets Corporate Bond ETF (EMCB | C).

With so many viable choices, investors have to think about more than just the opportunity for more yield.

Emerging Market Debt’s Upside Surprise

Over the last few years, emerging markets have been drinking a toxic cocktail of currency head winds, slowing growth and crashing oil prices. This is a drink that would knock any market out, but it has had particular negative impact on emerging markets.

Likewise, the doom and gloom has not been limited to equities. Emerging market debt struggled in 2015, falling victim to exchange rates.

The drop in value of EM local debt ETFs in 2015 was directly tied to the loss in EM currencies, as U.S. dollar-denominated EM debt finished relatively flat.

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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