Emerging Market Retreat-Global bonds part three

Leave a comment

Our last piece on global bonds focused on non-US Treasury ETF instruments in the developed world. The recent sell off in most emerging debt and currency markets requires the attention of investment committees and Zenith Portfolio Strategies. This would not be a major concern except that there is more than one fire out there. Argentina is in a currency crisis, Turkey is in a massive structural crisis that continues to weigh on risk assets and China is feared to be slowing given recent economic numbers. The Ukraine is crumbling amid the fight between Brussels and Vladimir Putin. South Africa is raising rates to shore up its currency although not to the magnitude that Turkey has done in desperation.

We would like to state that we do not know the endgame with respect to this series of shocks however, it is a possibility that the emerging world needs to truly “reset” before this is over. That would include structural reforms that bolster their fiscal and monetary position through means other than a dependence on fickle foreign capital. When investors leave the US and sell the dollar, there is not as high of a chance of an immediate crisis as our dollar market is deep. The Turkish, Argentinian and South African markets are not as liquid or trusted. Also, raising their cost of capital at a time when economic growth is slowing is not a healthy mix even if it supports the currency for a time.

It is against this backdrop that we revisit emerging market products that we do not feel warrant a place in most investor’s portfolio. We began the discussion in our blog back on October 28th, 2013 along with recommendations.

Here are the two ETFs we featured back in October that have performed poorly.

I-Shares Emerging Market Local currency bond ETF (LEMB) -12% 1 yr return

I-Shares J.P. Morgan USD Emerging Market bond ETF (EMB) -10% 1yr return

Three additional products that represent areas of the emerging bond markets.

Wisdom Tree Emerging Markets Local Debt Fund ETF (ELD) -17% 1yr return

I-Shares Emerging Market Corporate Bond ETF (CEMB) -7.97% 1yr return

I-Shares Emerging Market High Yield Bond ETF (EMHY) -12.21% 1yr return

Here are basic performance numbers from three active managers over a 1yr time frame.

Pimco Emerging Market Corporate Debt Fund $ (PEMIX) -7.40% 1yr

TCW Emerging Markets Bond Fund (TGINX) – 9.9% 1yr

Double Line Emerging Markets Income Fund (DBLEX) -6.6% 1 yr

Van Eck Unconstrained Emerging Market Bond Fund (EMBYX) -12% 1 yr

Brief investment return comparison

A passive approach that sought representation in all segments 1 yr ago would have made equal weight placements in $ sovereign debt, local currency sovereign debt, $ EM corporate debt and $ EM high yield debt.

CEMB, EMB, ELD, EMHY are a few of the instruments that can provide this exposure. An equal investment in all four would have produced a return of -11.79% over the last year.

Interestingly, as much as Zenith touts active management in this area of the capital markets, one fund did worse than this combination by a little bit and did not substantiate our thesis while one fund beat the combination handily. That is a huge difference and supports at least in this case, the argument for active management.

Double Line has been much more tilted in favor of the dollar and EM corporate debt and both aided performance while Van Eck has been less prescient as they have a significant portion in sovereign local currency bonds.

This is not an indictment of Van Eck or full support for Double Line but rather a brief illustration that there is active management that can beat passive ETFs at least over this rough 1 yr period. They simply have the discretion to avoid some areas where the risk/reward is not advantageous.

We outline below the basic characteristics of two ETFs mentioned for your review. If you own them, please schedule an investment committee meeting to determine your stance on the funds’ prospects given its holdings and risk to reward characteristics.

Wisdom Tree Emerging Markets Local Debt Fund ETF (ELD)

This ETF holds emerging market country debt denominated in local currency. The Asia region holds 37%, Europe-Middle East and Africa 32% and Latin America 30%. The duration is 4.6 with an SEC yield of 5.45%. This ETF holds approximately $1 billion in assets and should be sold for the following reasons. While the interest rate risk is reasonable for the yield compensation, given the fast moving dynamics of these markets, it lacks necessary nimbleness. There is value in some emerging market bonds in developing countries but it takes a strong team to determine those values amid a crisis type rout.  There was almost no chance that this ETF would have stepped out of the way of the runaway train. You would need an in-depth view on the monetary policies of the major countries’ and regions’ in addition to a clear view on real interest rate value to warrant a purchase.

I-Shares Emerging Market High Yield Bond ETF (EMHY)

This ETF has below investment grade debt in emerging market countries. The top three countries are Turkey, Indonesia and Venezuela. The duration is 5.44 with an SEC 30 day yield of 6.85%. This ETF holds approximately $191 million in assets and should be approached carefully. The interest rate risk is reasonable for the yield compensation although credit conditions need to strengthen and interest rates need to be stable to falling in order for this to work out well. Unless your investment committee has a strong positive view on the return and risk characteristics of this instrument and the underlying country’s monetary policy, currency outlook and credit conditions for the underlying corporate debt, then an active manager would likely be a better option.

Zenith recommends that firms sell any and all of these holdings. The portfolios are positioned in very specific and difficult areas of the capital market. Our solution is to vet high quality managers with a risk mitigation process in place.

Our next piece will make recommendations with regard to global and emerging market managers worthy of consideration for your investment portfolio.

Sincerely,

Tom Koehler, CIO

“Bond markets represent a complex asset class and while we covered a small amount, there is a lot more information needed prior to making an investment decision. Let us know if we can provide more information to help in that process.”

Global Bonds Part Two

Leave a comment

Our last piece on global bonds talked about the larger opportunity set outside of the US.  That set includes developed and developing markets that range from Sweden to Indonesia.

In this piece, we will begin to examine a few developed market products that we do not feel warrant a place in most investor’s portfolio.

SPDR Barclays International Treasury Bond ETF (BWX)

This ETF has developed country debt mostly in Europe and Japan. The top three countries are the UK, Japan and Italy mostly in government bonds. The duration is 7 with an SEC yield of 1.66%. This ETF holds approximately $2 billion in assets and should be sold for the following reasons. The interest rate risk is much too high for the yield compensation. There is value in some government bonds in developed countries but it takes a strong team to determine those values. Also, it has a focus on investment grade, non-dollar debt so an investor is stuck in non-dollar bonds and has little opportunity for high yield opportunities. We understand the goal is to expand the Treasury Bond opportunity set but unless your investment committee has a strong positive view on the return and risk characteristics of this instrument, it should be sold. You would need an in-depth view on the monetary policies of the major countries in the ETF.

SPDR Barclay’s Short Term International Treasury Bond ETF (BWZ)

This ETF has developed country bonds mostly in Europe and Japan. The top three countries are Japan, Germany and Italy, mostly in government debt. The duration is 1.81 with an SEC 30 day yield of .63%. This ETF holds approximately $238 million in assets and should be sold for the following reasons. The interest rate risk is too high for the yield compensation and while there is value in some government bonds in developed countries, it takes a strong team to determine those values. Unless your investment committee has a strong positive view on the return and risk characteristics of this instrument and the underlying country’s monetary policy, currency outlook and credit conditions, then an active manager would likely be a better option.

I-Shares 1-3 year International Treasury Bond ETF (ISHG)

This ETF has developed country bonds in Europe and Japan. The top three countries are Japan, Italy and France mostly in government debt. The duration is 1.81 with an SEC 30 day yield of .23%. This ETF holds approximately $173 million in assets and should be sold for the following reasons. The interest rate risk is too high for the yield compensation and the investment grade non-dollar debt focus excludes high yield and dollar denominated debt. Unless your investment committee has a strong positive view on the return and risk characteristics of this instrument and the underlying countries, it should be sold.

I-Shares International Treasury Bond ETF (IGOV)

This ETF has developed country bonds mostly in Europe and Japan. The top three countries are Japan, Italy and France mostly in government debt. The duration is 6.85 with an SEC 30 Day yield of 1.37%. This ETF holds approximately $600 million in assets and should be sold due to the following reasons.  The interest rate risk is too high for the yield compensation and the investment grade non-dollar debt mandate is inflexible. Once again, unless your investment committee holds a strong positive view on the return and risk profile of this ETF, it should be sold.

Zenith recommends that firms sell any and all of these holdings. The portfolios are reasonably stuck in non-US Government Debt in advanced countries in their local currency. These two attributes place an investor in an inflexible position. Additionally, they are left with uncompensated interest rate risk even with the short term funds.

We have not covered fees as we would not invest in these funds even if the fee was zero as they do not possess any attractive attribute for investment. The only way a firm could legitimize a purchase is if they hold a strong view on the monetary policy, interest rate direction and inflation pressures in Japan, greater developed Europe as well as Great Britain. A seasoned manager would best be suited to extract the value in each of these markets given a solid team with macro experience.

Sell and avoid all four of these products.

Sincerely,

Tom Koehler, CIO

Sustainability and Investing

Leave a comment

Sustainable Investing-SRI/ESG

            “Sustainable investing integrates rigorous environmental, social and governance (ESG) analysis into security selection and portfolio construction.”

            We believe at Zenith that there is merit to this area of the investment world as more pools of investment capital are demanding accountability beyond share price appreciation. These activist investors are calling on corporations to examine their ethos and business practices and they are grading them. This is becoming a joint effort among the public and non-profit arenas.

            For instance, the Dow Jones Sustainability™ Indices are maintained collaboratively by S&P Dow Jones Indices and RobecoSAM. Following a best-in-class approach, the indices measure the performance of the world’s sustainability leaders. Companies are selected for the indices based on a comprehensive assessment of long-term economic, environmental and social criteria that account for general as well as industry-specific sustainability trends. Only firms that lead their industries based on this assessment are included in the indices.

            CDP is an international, not for profit organization providing the only global system for companies and cities  to measure, disclose, manage and share vital environmental information. CDP works with market forces, including 722 institutional investors with assets of US$87 trillion, to motivate companies to disclose their impacts on the environment and natural resources and take action to reduce them. CDP now holds the largest collection globally of primary climate change, water and forest risk, commodities information and puts these insights at the heart of strategic business, investment and policy decisions.

            These type of forces will continue to gain momentum in our estimation as the costs of not adhering to sustainable policies will appear to be too high and investors will demand a higher degree of corporate governance that balances profit and an eye to the future.

            We will keep you updated as we uncover managers that add value and that adhere to SRI/ESG principals.

 

Sincerely,

Tom Koehler, CIO