EM Debt ETFs Move Into Mainstream
October 24, 2012
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[This article originally appeared on our sister site, IndexUniverse.eu.]
Not all that long ago emerging market debt was the preserve of sophisticated investors with a high tolerance for the risks and volatility associated with this asset class. But emerging market debt has moved into the mainstream with the development of bond indices and, in recent months, money has flooded into ETFs that track the most popular indices.
“Year-to-date there has been over US$3 billion invested in iShares’ emerging market debt ETFs. Including funds from other providers, the total inflows to emerging debt so far this year are US$5.2 billion,” said Blanca Koenig, fixed income specialist for BlackRock's ETF business, iShares.
The majority of those US$5.2 billion inflows have been in the U.S. market. U.S.-listed emerging market debt trackers have gained US$3.7 billion in assets this year, while Europe-listed funds have added US$1.5 billion.
Most ETF investors—around 80%—choose funds tracking an index of sovereign debt denominated in foreign currencies, such as JP Morgan’s Emerging Market Bond Index (EMBI). The EMBI includes dollar-denominated debt issued by emerging market sovereigns or quasi-sovereigns.
In Europe, BlackRock also offers access to sovereign emerging market debt denominated in local currencies through an ETF that tracks Barclays Capital’s Emerging Markets Broad Local Currency Bond Index. State Street also offers a European ETF tracking the same index.
Though local currency emerging market debt ETFs lag foreign currency debt trackers in popularity, the assets invested in these two funds are now substantial (iShares’ local currency ETF has US$480 million in assets, while State Street’s has US$385 million).
“These ETFs are a great product. In the past, the only way to access this asset class is through mutual funds, which have higher fees. And mutual funds are designed to be held over the long term, whereas ETFs are more tradeable,” said Peter Tchir, founder of TF Market Advisors and a former investment bank credit trader.
Not only do emerging market debt ETFs make it much easier for investors to access this asset class, but they can also use these products to execute short-term tactical asset allocation strategies, added Tchir.
The popularity of emerging market debt ETFs over this year can, in large part, be attributed to investors turning to other sources of yield as returns on more traditional fixed income asset classes continue to be dismally low.
“For example, the iShares JP Morgan dollar emerging market debt fund has a yield of over 4% at the moment. That’s attractive if you compare it with the yield on US treasuries,” iShares’ Koenig said.
But higher returns usually come with more risks. Many investors can still remember the emerging market debt crisis of 1997/98, when a series of countries suffered major devaluations and defaults. Is there a way for the providers of the emerging market debt ETFs to control these risks?
“Minimising the risk for investors is about choosing the underlying index wisely and running the ETF to ensure that liquidity is well managed,” Koenig said.
JP Morgan’s EMBI is a diversified index with relatively liquid bonds which all settle in the developed markets. There are more operational issues with a local currency index. “That’s why we choose the Barclays index for our local currency ETF because it includes only the most liquid and accessible countries,” said Koenig.
Once the index has been chosen and the fund is running, there has to be some freedom in the way it is run to ensure this can be done efficiently. “We buy the physical bonds of the index but not in exactly the same weight. Our choice depends on the liquidity of the different instruments,” added Koenig.
This approach can increase the tracking error but only slightly. “For example, we only have a forward-looking tracking error of around 10 basis points on the Barclays index ETF product,” said Koenig.