Emerging Market ETFs and True Diversification

I recently received an e-message from a global investor. He's experienced terrific gains in broad-based Asian ETFs such as the Vanguard Asia Pacific Fund (VEA) and individual country ETFs like the iShares MSCI South Korea Index (EWY). Moreover, he's looking to increase his stock allocation in emerging markets like Thailand and Vietnam.

Yet this individual has been haunted by one undeniable truth; specifically, when the U.S. stock market goes down, stock assets around the world tend to struggle even more. "Shouldn't my diversification abroad help offset losses in U.S. stock assets?" he asked.

Actually, I've addressed this topic in many previous posts. "When ETFs Attack" explained how one can offset downdrafts with less correlated asset classes such as currencies and commodities. "The Old Asset Allocation Mare" discussed the possibility of using strategic ETFs like those involved in covered calls and currency harvesting. In this article I gave a thumbs up to foreign bonds via the SPDR Lehman International Treasury Bond Fund (BWX).

Simply stated, diversification into foreign stocks is very unlikely to cushion an individual from a U.S. stock market downturn. In fact, most stock assets have always moved in the same direction -- small, large, growth, value, domestic, international. It's just been a matter of degree.

In the 21st century, even different asset classes such as U.S. stocks and U.S. bonds have essentially moved in the same direction. The assumption that one could hold U.S. stocks and U.S. bonds alone... perhaps in a 60/40 mix... has not painted an attractive portrait of diversification either.

If stocks and bonds are moving in the same direction, and the only difference tends to be the amount of perceived risk associated with the asset class, then you are no longer achieving true diversification. You have to look to additional outlets.

The BWX fixes the problem to some degree. It cushions a portfolio from stock risk, offers approx 4.35% of annual income, works as a hedge against a falling U.S. dollar and won't move positively or negatively with the S&P 500.

Still, some people are concerned with "portfolio drag." That's a term one associates with the drag on overall portfolio returns that can come about with a larger bond component.

Enter a unique alternative: The Emerging Markets Sovereign Debt Portfolio (PCY). Similar to the bond holdings of developed countries in BWX, the emerging market exchange-traded vehicle only holds government issued debt. You don't have to worry about a company going belly up... a country itself would have to default on its obligation.

Even with the possibility of an emerging country defaulting, a sovereign debt portfolio holds roughly 20 countries. This reduces the risk of any one country affecting the entire pot.

Unlike the BWX, where you might expect 4.35% plus some capital appreciation, PCY tracks an emerging bond index with a phenomenal back-tested track (15%+ annualized since early 1999).

But let's face it. We wouldn't want emerging debt for the sole purpose of back-tested returns. We want the PCY because it represents an asset class that moves independently of other asset classes.

And then there's another reason. If China, India and other so-called "emergers" are anywhere near "bubble status," you're going to want the country debt obligation, not corporate debt.

BWX vs. PCY 2 month chart: