Evaluating A High-Flying Emerging Markets ETF

After several years of being over-laggards, emerging markets assets are finally delivering for investors. And, the resurgence of developing world debt is a big reason why.

In fact, emerging markets fixed income exchange-traded funds are performing on par with their equity-based counterparts while exposing investors to significantly less volatility.

PowerShares Emerging Markets Sovereign Debt Portfolio

Just look at the PowerShares Emerging Markets Sovereign Debt Portfolio PCY. The dollar-denominated PCY, the second-largest emerging markets bond ETF by assets, is up 16.3 percent year-to-date, or just 50 basis points behind the MSCI Emerging Markets Index. However, PCY's annualized volatility is just about a third of that of the MSCI index.

So, there are good reasons for PCY to be S&P Capital IQ's focus ETF for October. Those reasons include passive ETFs such as PCY being better bets than their actively managed rivals.

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“We think emerging market debt products have garnered attention in 2016, as they generally sport relatively appealing yields. However, according to the SPIVA Mid-2016 Scorecard from S&P Dow Jones Indices, 11 percent of actively managed emerging market debt mutual funds outperformed the Barclays Emerging Markets Index in the three-year period ended June 2016. While some think the high costs of active management is the culprit, these active funds lagged by 311 basis points,” said S&P Capital IQ in a note out Thursday.

Justification

Two reasons explain investors' enthusiasm for ETFs like PCY this year. First, and most obvious, is the world is awash in low- and negative-yielding bonds, making PCY's 30-day SEC yield of 4.74 percent seem all the more attractive. Second, the Federal Reserve has held off on raising interest rates, suppressing the dollar in the process while providing a tailwind to emerging markets bonds that were once imperiled by the strong greenback.

Emerging markets bonds' sensitivity to interest rates is easy to figure out. Emerging markets governments and some corporations binge borrowed in dollars during the various versions of the Fed's quantitative easing programs. It looked smart, as the dollar weakened against a plethora of developed and emerging currencies, but those emerging markets borrowers were caught off guard when the dollar started soaring several years ago.

Liquidity is another concern with bond ETFs, particularly those holding more exotic fare such as emerging markets debt. Fortunately, PCY passes the liquidity test.

“In addition, the ETF's liquidity is strong to us. Average daily volume has increased in recent months and 1.8 million shares traded on a daily basis in the past month, up from 1.4 million during last six months. Strong volume, as percentage of its $4 billion in assets, has helped to keep trading costs low. PCY has a $0.01 bid/ask spread,” added S&P Capital IQ.

Investors have added $955.3 million to PCY this year, a total exceeded by just three other PowerShares ETFs.

Full ratings data available on Benzinga Pro.