PowerShares Emerging Markets Sovereign Debt ETF: Let the Games Begin

Oct.16.07 | About: PowerShares Emerging (PCY)

It's been a long time coming, but it's finally arrived.

Investors can now buy the betas for all the major asset classes. The latest arrival is PowerShares Emerging Markets Sovereign Debt ETF (Amex: PCY), which was launched last week. As a result, all ten of the major capital and commodity asset classes are now available for the first time in index-tracking exchange-listed securities (see our nearby ETF list in the left-hand column under Standard Betas).

PCY is notable for the fact that it's the first time that emerging markets debt has been indexed for the U.S. investing public. But as with any new index fund, the first question is always: What's the underlying benchmark?

PCY tracks DB Emerging Markets USD Liquid Balanced Index. In deference to the regulatory and trading demands for ETFs, the benchmark sacrifices scope in exchange for a relatively selective approach that focuses on "the most liquid" dollar-denominated emerging markets debt. A similarly narrow approach is used for profiling the respective asset classes targeted by SPDR Lehman International Treasury Bond ETF (Amex: BWX), and iShares iBoxx $ High Yield Bond ETF (Amex: HYG).

As for PCY, one to three bonds are held for each country represented in the portfolio allocation. How are the representative bonds chosen?

Here's the explanation from Deutsche Bank, which manages the index:

The index selects, from the eligible bond(s), those with the biggest Z spread from each country at rebalancing. Roughly speaking, this is the bond that has the highest likely excess return compared to swaps among a group of bonds from the same country with similar risks and very high correlation. This Z Spread method is an effective and simple way to pick up relative values amongst bonds with different maturities from the same emerging market country.

The leading country weights for PCY's index as of June 30 were:

1. Columbia (6.54%)
2. Turkey (6.42%)
3. Brazil (6.33%)
4. Peru (6.32%)
5. Bulgaria (6.31%)
6. Philippines (6.31%)

Although PCY is new, a back-tested calculation of its index posted a 17.07% annualized return, and a 5.60% annualized volatility for March 1, 1999 through August 23, 2007, according to Deutsche Bank. Of course, one must take such history with a grain of salt. All the more so, given the potent bull markets blowing through emerging markets generally in recent years.

As a long-term proposition, however, the allure of emerging markets debt boils down to diversification. The asset class has a history of moving independently from the other leading slices of world's capital and commodity markets. And as the financial academics have long proclaimed, mixing assets with low correlations promotes superior risk-adjusted portfolio returns.

WIth that in mind, consider how another emerging markets debt index compares to the usual benchmark suspects in terms of correlations for monthly total returns:

On paper, at least, emerging markets bonds look encouraging. But, as always, there are caveats. That starts with the fact that the asset class, like so many others, has run skyward for some time. That may or may not discourage investors, but at least they should be aware of the history before jumping in.

Meanwhile, there's the question of whether the underlying index for PCY effectively captures the emerging markets debt profile. Based on the benchmark's quantitative history, it appears to be a serviceable proxy. But one might wonder how the index will fare in the real world via an ETF, which carries a 50-basis-point fee. The expense, by the way, is on the low side compared with the actively managed mutual funds in the niche. But within the ETF universe, a 50-basis-point fee is far from the lowest, although it matches the cost for the recently launched SPDR Lehman International Treasury Bond ETF, which targets foreign government bonds from developed markets.

Ideally, we'd like to see a range of ETF and mutual fund choices for each of the major asset classes. Competition, after all, ultimately serves the end users. That happy state of affairs prevails in some corners, most notably for U.S. equities. But evolution is a slow process. For the moment, let's be happy with the fact that all investors can now build institutional-quality portfolios by way of the world's major betas. By our definition, that's progress. But the game has only just begun.

Check out the Seeking Alpha ETF Selector for more information.