High Conviction: Emerging Markets Debt Offers Strong Potential

| About: PowerShares Emerging (PCY)

John Middleton, CFA, CAIA joined Clinton, NJ based Brighton Financial Planning in August 2008 and assumed ownership in February 2010. Prior to Brighton, John spent 7 years with the Invesco Quantitative Strategies Group as a Senior Director and Client Portfolio Manager. While with IQS, John was responsible for over 50 clients worldwide with more than $2.5 billion in assets under management.

Seeking Alpha recently had the opportunity to ask John about his current asset allocation and perspective on opportunities in this market.

In your portfolio(s) currently, how are you allocating among different asset classes?

We approach asset allocation from a similar perspective to institutional investors. We focus on long-term absolute returns and risk management with an emphasis on downside protection and inflation protection. Along these lines, we think in terms of core/satellite investing. Our core is anchored by global equity and fixed income managers. We have conviction regarding geographic allocations but prefer to let proven global managers make this decision. We view the core as strategically allocated and will rebalance it infrequently.

We then focus on satellite management. The satellite is treated tactically and is more frequently rebalanced. The intent is either return enhancement or risk management.

Currently, we’re minimizing our exposure to domestic equity and increasing exposure to emerging markets. We believe the emerging markets have stronger balance sheets, more prudent fiscal and monetary policies and greater long-term growth potential than the developed markets.

We also have exposure to commodities, for return potential, long-term inflation hedge and diversification. We favor strategies which invest in commodities producers rather than use futures contracts.

Finally, we have exposure to domestic hedged strategies. We do have concerns about near-term domestic equity performance but the equity markets are notorious for being irrational for much longer than a rational investor would expect. Thus, we don’t want to eliminate the exposure but do want to hedge against the risk of a correction. We’re using three strategies – one long-biased, one market neutral and one which employs a “cashless” collar.

Which single asset class do you think will perform best in 2010?

We like emerging markets fixed income. We’re not convinced that global economies are as strong as equity investors appear to believe. Viewing total return as capital gains plus income, we’re expecting income to be a primary driver of total return in 2010.

Emerging markets have strong balance sheets, responsible fiscal and monetary policy and better long-term growth prospects. Of course, they’re not without risk. Many are dependent on foreign consumption, particularly on U.S. consumption, and the lack of foreign demand will weigh on their economies. However, we believe these markets still offer strong potential in 2010 with less risk than developed markets.

What stocks or ETFs do you choose to capture that?

Among ETFs, we like the PowerShares Emerging Markets Sovereign Debt Fund (NYSEARCA:PCY). The ETF is based on the Deutsche Bank Emerging Markets USD Liquid Balanced Index. The index is well balanced and the methodology is well-defined. Long-term performance is excellent with low volatility. Finally, fees are reasonable at .50%. Duration is on the long side at just over 7 years but we’re comfortable with that given our view on near-term global inflation prospects.

For emerging market bonds, why do you like PCY more than EMB?

Due to the lower fees, higher yield, and slightly longer duration (a current preference). Credit quality, number of holdings and index construction are similar.

Neither has a long enough track record to evaluate based on performance (both are just over 2 years old). I don't think the longer duration is a negative, as I don't see much risk of global inflation in the near term. Taking the duration risk provides for the slightly higher yield.

On emerging market debt, there's been some concern recently that it's in a bubble and/or that some nations could default. What are your thoughts on that?

I recognize the risks of investing in emerging markets, whether fixed or equity, and note many are concerned about "bubbles". I argue that the emerging market economies are healthier than advanced markets with better balance sheets, better fiscal and monetary policy and better growth prospects. Consequently, valuation concerns can be addressed in part by considering the possibility that the risk premium is shrinking - the probability of a default by an advanced country is increasing as their debt burdens skyrocket and rating agencies threaten downgrades (U.S.).

Corporate debt (Berkshire, in particular) was recently trading below equivalent U.S. Treasuries (2 year). The "bubble" may in fact be a "bubble" but it could also be a re-assessment by the market of the relative risks of investing in advanced vs emerging market debt.

Consider, in aggregate (data from the IMF):

  • Emerging markets had a current account surplus of $355 billion which is forecast to grow to almost $550 billion in 2010 while advanced markets had a current account deficit of ($262) billion which is forecast to decline only to ($161) billion in 2010.
  • Emerging markets had GDP growth in 2009 of 1.7%, forecast to grow to 5.1% in 2010 while advanced markets had GDP growth of (3.4%) in 2009 and forecast growth of 1.3% in 2010.
  • Emerging markets had gross national savings of 33% (of GDP) in 2009 and are forecast to have 34% in 2010, while advanced markets had national savings of 17% in 09 and a forecast of 18% in 2010.
  • Emerging markets had inflation of 5.5% in 09 and are forecast to have inflation of 4.9% in 2010 while advanced markets had inflation of .1% in 09 and are forecast to have inflation of 1.1% in 2010. Neither is threatening to bondholders.

All of these statistics suggest emerging markets are healthier than advanced markets currently and may not deserve the high risk premiums previously assigned. If correct, a re-assessment of relative risk would lead to a reduction in yields.

What instruments do you generally use to capture particular asset classes?

We believe active management can add value and do use both active and passive strategies. We use open-end, closed-end and exchange traded funds as vehicles to implement our strategies. We determine our asset allocation first and then identify the strategies we believe will best meet our objectives. We consider active vs. passive, management tenure, investment philosophy and strategy, long-term performance including yield, volatility, premium/discount and fees when evaluating our options.

We’re currently using open-end funds for our global exposure, closed-end funds and exchange-traded funds for certain fixed income exposures and closed-end funds for sector strategies.

Have any new instruments emerged in the past few years that you've adopted in your portfolio construction?

We’re intently watching the emergence of new alternatives strategies in the ETF marketplace. In particular, IndexIQ has hedge fund replication and arbitrage strategies that appear very interesting.

We focus on the mass-affluent market and would like to see more “hedge” like strategies available to our clients. ETFs offer great potential as firms become more comfortable addressing the ’40 Act requirements regarding holdings reporting and short exposures.

Thank you very much, John.

Disclosure: Brighton Financial Planning is long PCY in client accounts

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