One of the primary advantages of exchange-traded funds (ETFs) is increased access to previously hard-to-reach asset classes. ETFs help investors gain exposure to asset classes ranging from small-cap gold miners to short-term junk bonds to international real estate stocks and emerging markets bonds.
Emerging markets sovereign debt can be easily accessed via ETFs, such as the iShares J.P. Morgan USD Emerging Markets Bond ETF (EMB) and the PowerShares Emerging Markets Sovereign Debt Portfolio (PCY). EMB and PCY are the two largest dollar-denominated emerging markets bond ETFs trading in the U.S. with assets under management of $10.3 billion and $4.2 billion, respectively.
In fact, EMB is the largest emerging markets debt fund -- ETF or mutual fund -- in the world and its Europe-listed equivalent is also one of the largest funds in the world tracking debt issued by developing economies. However, these ETFs and others like them have plenty of critics.
Just as there have been liquidity concerns regarding ETFs representing other areas of the bond market, including U.S. high-yield corporate debt, similar concerns linger when it comes to ETFs like EMB. Critics assert that tracking error, or an ETF's ability to closely mirror its underlying index, is an issue with emerging markets bond funds. (For more, see: A Big Junk Bond ETF Approaches a Milestone.)
“Debt issued by governments and companies in emerging economies can be harder to buy and sell. Higher transaction costs have resulted in tracking errors in emerging-market bond ETFs,” reports the Wall Street Journal. “The complexity of these bonds, particularly those of far-flung markets, can also give an edge to active bond managers, who in some cases have spent decades gaining an understanding of idiosyncratic political and currency risks.”
Currency risk is another consideration with emerging market bond ETFs. EMB and PCY hold debt denominated in dollars, which introduces an element of sensitivity to U.S. interest rate policy. If the dollar strengthens on the back of higher interest rates, it becomes costlier for emerging markets borrowers to service that debt.
Likewise, weaker emerging markets currencies can be an issue for ETFs such as the VanEck Vectors J.P. Morgan EM Local Currency Bond ETF (EMLC), which holds bonds denominated in local currencies. EMLC is nearly seven years old and has $3.2 billion in assets under management, making it one of the largest local currency emerging markets bond ETFs trading in the U.S. (For more, see also: Top ETFs and What They Track: A Tutorial.)
The pros and cons of emerging markets bond ETFs are sparking debate among issuers of these products and the active managers that compete with ETFs.
“Broadly, the average emerging-market bond ETF has returned over a five-year period 1.66% annually, while their active counterparts returned 1.95%, according to Morningstar Inc. data. From the start of 2017 through Wednesday, the average total return on emerging-debt ETFs was 4.15%, while the comparable figure for active funds was 5.32%. Over three years, ETFs slightly outperformed active funds,” according to the Journal.