Fundamentals Could Lift This EM Bond ETF

When it comes to emerging markets ETFs, knowing what countries are left out of or only have minimal exposure in a particular fund is often as important as knowing what nations dominate that ETF.

At the equity level, ETFs with sizable weightings to the largest emerging markets have disappointed investors this year.

On the other hand, Indonesia and the Philippines, among others, have been sturdy performers while BRIC, South Africa and South Korea have wilted. Investors should apply a similar logic when it comes to bond ETFs because some funds indicate that what countries are excluded can be nearly as important as those that included.

That is the case with the WisdomTree Emerging Markets Local Debt Fund ELD. The WisdomTree Emerging Markets Local Debt Fund is the second-largest actively managed ETF on the market today and was the first to cross the much ballyhooed $1 billion in assets under management mark.

Few in the mainstream financial media either know that ELD is actively managed or that it is big because the powers that be opt to focus on just one actively managed ETF.

Since its debut in August 2010, ELD has returned just over 17 percent, a stout number and one that indicates active management is working here. Consider the case of Hungary. The volatile Eastern European nation accounts for nearly five percent of ELD's benchmark index, but the ETF makes no room for the financially troubled nation.

"Recently, the ratings agency Standard & Poor's announced that it was joining Moody's in lowering the outlook for Hungary's sovereign credit rating," said WisdomTree portfolio manager Rick Harper in a new research note. "ELD's portfolio management team has excluded Hungary from the portfolio ever since the Fund's inception for many of the same reasons discussed in the S&P report. Principally, we are concerned about the uncertainty of future action by government policy makers. After a breakdown in negotiations with the International Monetary Fund (IMF) disappointed markets last year, we remain skeptical about the path of governmental reform we believe is required to help improve Hungary's economy."

ELD's credit profile indicates investors are not taking on significantly higher credit risk with this ETF. About 61 percent of the ETF's holdings are rated A and BBB. Another 16.2 percent are rated either AAA or AA. Additionally, ELD offers ample exposure to developing markets that could soon be on the receiving end of higher credit ratings.

For example, ELD has a 3.72 percent weight to the Philippines, which was recently promoted to investment-grade status. Last month, Standard & Poor's said it could boost Peru's credit rating, according to the Wall Street Journal. The Andean nation represents 3.43 percent of ELD's weight.

Indonesia, Turkey and Colombia are all credible candidates for higher credit ratings and those countries combine for over 20 percent of ELD's weight. Indonesia is the ETF's third-largest country allocation at 10.33 percent.

Again, sometimes what countries are excluded in an emerging markets bond ETF are just as important those that are include. Hungary proves the point.

"Currently, Hungary is rated BB (two notches below investment grade) by S&P, on par with borrowers such as Portugal and Guatemala," said Harper in the note. "S&P notes that the government's predictability and credibility has continued to weaken in the past year. Questions about central bank independence, a large percentage of debt held by foreign investors, and a banking system with large foreign liabilities pose significant risks, in our opinion."

ELD has a 30-day SEC yield of 3.91 percent and an effective duration of 4.87 years. The average yield to maturity on the ETF is 4.57 percent. ELD, which has an expense ratio of 0.55 percent, now has $1.9 billion in assets under management, up from $1.6 billion in early January.

For more on emerging markets bond ETFs, click here.