Just One ETF: Emerging-Market Debt for Lower-Volatility Diversification

| About: iShares J.P. (EMB)
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Several times a week, Seeking Alpha's Jason Aycock asks money managers about their single highest-conviction position - what they would own (or short) if they could choose just one stock or ETF.

Casey Smith is president of Wiser Wealth Management, a fee-only RIA based in Marietta, Ga. He formed the firm as CT Smith Financial Services in 2001. Kyle Waller is research analyst for the firm.

Which single asset class are you most bullish (or bearish) about in the coming year? What ETF position would you choose to best capture that?

As a firm, we don’t practice making bets on investments but rather view investments in the context of asset allocation and the role they play in portfolios. Looking at our portfolios, we’re most excited about emerging market bonds in the next year, and we use iShares JPMorgan USD Emerging Markets Bond Fund (NYSEARCA:EMB).

How does EMB fit into your overall investment approach?

EMB is a great ETF, poised to capture returns from emerging market economies, benefiting from their interest rate environment, and maintaining a low correlation to the U.S. stock market. Since EMB provides high yield and high absolute returns from emerging market growth, we have EMB in every model portfolio across the risk spectrum: aggressive through conservative. It’s a great fit in so many places.

Because it has a lower volatility than emerging market stocks and pays high dividends from the bonds’ coupon payments, it is a good fit for a conservative portfolio in small portions - and in aggressive portfolios, EMB adds a diversification layer to where our emerging-market exposure is coming from. The bonds included in the ETF are issued by emerging market governments in the U.S. dollar, which adds another layer of protection from volatility.

As an overarching investment strategy, we implement a passive asset allocation approach and construct portfolios entirely from exchange-traded funds.

Given our current client base, we concentrate heavily on building conservative portfolios, which can be fully invested throughout different asset classes and directly produce income. This has been quite a challenge for us, as bonds provide income and lower volatility risks while certain stock funds have higher yields. However, we are very conscious of not simply adding risk to a portfolio just to generate income.

Tell us a bit more about what makes emerging-market bonds your top pick.

The global financial landscape is currently in a state of change. Foreign investments are now part of the average person’s portfolio. Even some U.S. stock mutual funds include foreign investments to gain an edge. Investing globally is now easier than ever.

EMB chartThe developed world has fully embraced high levels of debt, and while most governments and investors see it as a problem and some are even trying to de-leverage, we are stuck in a place where debt feels necessary to keep the economy moving along. In light of this, emerging-market countries look less indebted, despite the fact that a major factor in becoming a developed economy comes from using national debt to build infrastructure and use natural resources. In the long run, any investment in emerging markets is a bet on the working class and their ingenuity.

However, EMB is a bet on governments and its performance should be more effectively able to reflect political and fiscal decisions being made in the country, and to aggregate overall growth rather than individual company success.

I also like the idea of getting income from high-growth categories like emerging market bonds. We’re careful with how much of this fund we use, since we know it has the potential to bite, but we’ve seen more steady growth and high yields from this fund relative to other emerging-market products.

Are there alternative ETFs that could be used to capture the same theme? What makes EMB your first choice?

There are a couple of ETFs that cover similar bonds, like the PowerShares Emerging Markets Sovereign Debt Portfolio ETF (NYSEARCA:PCY) and a new WisdomTree ETF (NYSEARCA:ELD) that has bonds issued in local currency.

However, as we have been focused on a passive ETF and really like the feature of these bonds being U.S. dollar-denominated, EMB has really been our main pick for this asset class. EMB, unlike PowerShares’ PCY, has some partially state-owned corporate bonds, but for the most part remains an ETF of sovereign debt. EMB has about 65 holdings, while the PowerShares product has 56. Diversification really matters to us and the yields are comparable. There’s a slightly different methodology for how the indexes are made up, and we like how EMB leans towards bonds from Brazil and Mexico.

A big factor for holding on to EMB is that during the financial crisis, EMB just lost less than its competitor. Looking at a report we completed in November of 2008, PCY was down about 35% and EMB had lost 24%. Emerging market bonds can be a confusing asset class and it’s good to understand structural differences among the ETFs but even more important to understand how this methodology difference actually performs under different market conditions.

Do relative durations of the holdings play a role in this choice? Seems like PCY is holding longer durations, which may have an influence depending on an investor's outlook on sovereign debt, inflation expectations, a "bond bubble," etc.

Duration has to be a consideration when investing in bonds. PCY and EMB are different ETFs with different index methodologies, thus we cannot just compare duration. Currently EMB has a lower duration. We think this may be why EMB has slightly trailed PCY's return and yield this year.

With both of these ETFs holding bond durations above seven years, we're not trying to make any big statements about interest rate movements. We are willing to accept the higher duration risk since we have a positive long-term view about this bond asset class in our portfolios. On a relative basis, however, PCY has a duration of 8.03 years while EMB has one of 7.27 years. This is important on a relative basis in such a low-interest-rate environment where there's uncertainty about inflation, when rates will go up, and how the investment community will perceive those rate increases on bond valuations.

Does your view differ from the consensus sentiment in this asset class?

Robert Arnott has said that there exists an once-in-a-lifetime emerging-market bonds buying opportunity. I believe that uncertainty is really the general sentiment on the markets right now, including emerging-market bonds. I may not agree with a once-in-a-lifetime buying opportunity in emerging-market bonds, but I do believe that they’re poised to do some spectacular things within the next decade, and when uncertainty in the global market settles, I think EMB will be a leader in our portfolios.

What catalysts, near-term or long-term, could have a significant effect on this asset class?

I think the main catalyst for emerging market bonds would be for emerging market governments to become more stable relative to Europe and the U.S. There seems to be a certain tolerance given to developing nations to endure growing pains and make mistakes, however, I believe that the developed world could stand still and emerging markets would continue to catch up and have significant GDP growth.

I think we’re at the point in many emerging market countries, like Brazil, where they will be growing no matter what’s happening in the world. They may have a year where their stock market crashes or drops 60%, but I think an economy like that is strong enough to grow through it.

Also, political risk in emerging markets is extremely important. We’ve seen the center of market-moving action shift from Wall Street to Washington in the last three years, so we know what political risk means now. In the same way that bad political decisions hurt the U.S. economy and stock market, the right ones can cause huge votes of confidence from market players. Given risk in the U.S., I now better understand what it means and how costly or profitable it can be. I think the emerging-market countries with great leaders will have the potential to become global economic powerhouses.

What could go wrong with your pick?

There are always significant risks in every area of emerging markets, and so much could go wrong in emerging-market bonds, which is why we carefully allocate with this ETF. Emerging-market bonds are high-yield bonds with lower credit ratings. Emerging markets tend to lean heavily on natural resources, or a single or a few large sectors. Crises in emerging nations could shut down even some of the larger emerging-market countries. Bailouts aren’t guaranteed either.

There’s an issue with bond ETFs and bond indexes where the index rewards higher-debt companies and countries with higher holdings. We would be interested in a product that solved this potential risk. Severe interest rate movements would hurt this fund, and any emerging-market financial crisis would be a major problem.

Thanks, Casey, for sharing your choice with us.

Disclosure: Wiser Wealth Management is long EMB.

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