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Emerging Market ETFs: Where the Buys Are

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Many emerging markets have slowed down, but with their attractive demographics, the pace of activity could pick up sharply.

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At some point, emerging markets should start to play an increasingly bigger role in portfolios as investors revert to their risk-on posture. Before the Lehman Brothers meltdown, it was common for managers to allocate or suggest emerging market allocations of up to 35% for a portfolio; after the crash, this allocation was downgraded to about 10% to 15% of portfolios. This lower allocation comes at a time when emerging markets are selling at their lowest multiples in recent history. Previously China indexes sold upwards of 20 times earnings; today these indexes are selling at about half of that multiple. Other Asian ETFs are also selling at low multiples. Examples would be the Guggenheim Small-Cap China ETF (NYSEARCA:HAO) at nine times earnings, the iShares China ETF (NYSEARCA:FXI) at nine times earnings, WisdomTree Small Cap Emerging Markets Income ETF (NYSEARCA:DGS) at 10 times earnings, and WisdomTree Emerging Markets Income ETF (NYSEARCA:DEM) at nine times earnings.

The reasoning often given for their low multiples is that the economic activity in emerging markets could be slowing down. Most emerging markets have slowed, but with their attractive demographics, the pace of activity could pick up sharply. For example, China revised downward their GDP increase to a 7% rate. But compare that to the US and many other developed countries, many of which are estimating their GDP to increase at a 2% to 3% level. China has a much higher GDP growth outlook and sells at a much lower multiple -- in some cases, a 50% lower multiple.

Income Securities for a Climbing Interest Rate Environment

Raul Elizalde, president of Path Financial, notes in his latest newsletter that bond funds can be toxic to a portfolio when interest rates are trending upwards. The reason is that bond fund managers almost never hold bonds to maturity because funds are defined by their maturity targets, and this necessitates constant rebalancing to keep the fund's average maturity constant. When managers replace shorter bonds with longer bonds in an upward rate market, they are constantly buying bonds that will depreciate, and will later have to book a loss. This rebalancing leads to bond funds posting poor results on an overall return basis. Elizalde points out that interest rate cycles are very long, and he thinks we have probably seen the lows in this cycle.

Investors wanting to stay in short-term fixed income paper -- which makes sense, given that interest rates are probably headed higher -- could consider senior bank loans. Senior loans are debt issued by a bank and syndicated by banks or institutional investors. Senior loans make it possible for companies that are below investment grade credit ratings to have access to capital. Because the loans are lower quality, they pay higher yields than higher rated loans.

Senior loans, also called leveraged loans, offer some protection because they are secured by company assets such as property or equipment. Senior loans are usually floating rate instruments, and a floating rate provides protection from rising interest rates. Usually senior loans have rates that are set above the LIBOR rate, and are reset every three months. Senior bank loans are speculative, and pay a higher interest rate to reflect their higher risk. Included in the risks of senior loans is that if there is a recession in the US, more senior loans will default, causing payments from the issuers to be ceased or delayed.

Senior Loan ETF Investment Possibilities

The PowerShares Senior Loan Portfolio (NYSEARCA:BKLN) tracks the S&P/LSTA US Leveraged Loan 100 Index, which is a benchmark for the largest institutional leveraged loans based on market weightings, spreads, and interest payments. The index securities comprise 132 securities, and the majority of these securities mature between one and 10 years. Maturity dates are not as important as the fact that these securities reset, and with the average time to reset being just over 37 days, interest rate risk is minimal. Of course, security risk is high, as it is with all senior loans. Senior loans account for 89% of the index assets, with high-yield securities making up the remaining portion in the basket. Its recent SEC 30-day yield is 4.17%, which is a high yield for a short-term reset security. Note that the notes held by BKLN are low, with 44% of its holdings in B paper and 7% in CCC paper.

A step up in portfolio quality and a different methodology in managing the portfolio is offered by the SPDR Blackstone/GSO Senior Loan ETF (NYSEARCA:SRLN). A managed ETF might seem strange to ETF purists and few actively managed ETFs have gathered much assets. But in a space such as bank senior loans, experienced management could help cut down on risk and also enhance performance. SRLN is actively managed and uses senior loans to provide investors with high current income. The fund manager is GSO / Blackstone Debt Funds Management LLC, which seeks to use superior security selection to outperform the Markit iBoxx US Leveraged Loan 100 Index. To this end, Blackstone uses its credit analysis to rank senior bank loans, and attempts to buy and sell loan instruments at the right time. As an example, Blackstone seeks to acquire loans at good prices before they are added to an index, and sell loans before they are removed from an index. SRLN holds 99 securities, which gives broad exposure to many industries. The largest allocations are to the business, health care, and telecommunications industries. The time to reset is longer than the loans held by BKLN, but since the senior bank loan space is so specialized, having Blackstone to manage the investments might mitigate the risk that longer reset periods pose.

Another possibility to consider is the Highland iBoxx Senior Loan ETF (NYSEARCA:SNLN). SNLN seeks to match the price and yield performance of the Markit iBoxx Liquid Leveraged Loan Index, before fees and expenses. SNLN pays a higher SEC 30-day yield, and a higher yield to maturity than BKLN or SRLN, but its holdings are lower quality than the other ETFs.

Editor's Note: Max Isaacman is the author of Blizzard of Money, Winning with ETF Strategies, Investing with Intelligent ETFs, How to Be an Index Investor, and The NASDAQ Investor.
Max Isaacman and/or clients hold BKLN and SRLN.
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