Emerging markets fans: don't overlook bond funds
Emerging markets fans ignore bond funds to their detriment as they compare favourably with their equity fund peers
It's clear that investors have a pronounced preference for emerging markets equity funds over emerging markets bond funds. There is currently well over $18 billion in 91 UK-domiciled equity funds in the Morningstar Emerging Market Equity category, and a lot more in specific regional categories, while there is under $600 million in just seven UK-domiciled bond funds that make up the Morningstar Emerging Market Bond category.
This is surprising as while emerging markets equity funds have considerable long-term total return potential, the same is true of emerging markets bond funds. And while there are a number of strong equity offerings that focus on the developing world, including First State Global Emerging Markets Leaders and JPM Emerging Markets, there are also a few noteworthy fixed income offerings that concentrate on this area, including Investec Emerging Market Debt and Schroders Emerging Market Debt.
Meanwhile, though emerging markets equity funds compare favourably with their bond counterparts in some ways, the former don't measure up to the latter in several important respects. Here's how the two types of funds compare on the most important metrics.
Geographic exposure
Both types of funds are dedicated to investing in securities from the
developing world so they both deliver the exposure that investors seek
from emerging markets vehicles. But variations in the size of the equity
and fixed income markets around the developing world result in funds
with very different geographic biases.
Both types of funds have big stakes in Brazil, Mexico, and Russia, as those large developing nations have sizable fixed-income markets as well as substantial equity exchanges. But emerging markets bond funds typically provide little if any exposure to China, South Korea, Taiwan, or India, whereas diversified emerging markets equity funds normally have hefty weightings in all four. Those key Asian countries have far smaller bond markets than stock markets.
Conversely, the bond funds tend to have the bigger positions in several mid-sized nations--such as Peru, the Philippines, and Turkey--that are more important players on the fixed income side than on the equity side. And bond funds tend to have tiny stakes in a number of very small emerging countries that issue sovereign debt, such as El Salvador and Gabon, while equity funds ignore these nations because their equity markets are too new, illiquid, or inaccessible to be attractive. The end result is that the geographic exposure of the emerging markets bond funds is significantly less Asia-oriented and somewhat more diversified than that of emerging markets equity funds.
Diversification value
Emerging markets equity funds make pretty good diversifiers for most
investors' portfolios. Typical global large-cap equity funds in the UK
do not devote a large percentage of their portfolios to emerging
markets, focusing instead on developed Europe, the US and Japan.
Combined with the fact that developing markets often have periods where
they are out of sync with developed equity markets (not including the
current crisis), these funds make for good diversifiers. But emerging
markets bonds, which also behave differently from the emerging markets
equity, are even better diversifiers.
Volatility
Emerging markets bond funds are aggressive by fixed income standards.
They take on significantly more credit risk than all other types of
fixed income offerings except for high yield and bank loan funds. The
sovereign debt of Brazil, Mexico, and some other big issuers is now
investment grade, but it is at the low end of the range, while the
sovereign debt of many developing nations is below investment grade. And
though these funds focus on dollar-denominated developing markets debt,
most of them do have some exposure to local currency credits, and
emerging markets currencies are prone to extremely sharp upswings and
downturns. Thus, it comes as no surprise that emerging markets bond
funds have been the second most volatile type of fixed income offering
over time.
However, emerging markets equity funds are even more volatile than emerging markets bond funds. Equities are a much riskier asset class than bonds, and emerging markets equities are far more explosive than their developed markets peers due to a host of risks that prevail in the developing world. The emerging markets equity universe is dominated by a few sectors, including the highly volatile materials and energy areas, which exacerbates the situation. In addition, these funds are quite exposed to the gyrations of emerging markets currencies, because they tend not to hedge their currency exposures to significant degrees.
Returns
As could be expected, there's considerable upside due to the explosive
nature of diversified emerging markets equity funds. They can earn
spectacular gains when in the right climate. For example, they posted an
annualised return of over 40% from early 2003 through late 2007 as
favourable macroeconomic conditions fuelled a global equity rally and
the exceptional strength of most developing economies and other factors
caused emerging markets equities to lead the way. But emerging markets
bond funds also have substantial upside potential. Indeed, they produced
nearly 19% annualised returns over a three-year period in the 1990s, and
they enjoyed an impressive multi-year rally earlier this decade.
What's more, emerging markets bond funds have posted an annualised return of over 8% over the past 15 years, while emerging markets equity funds have produced an annualised return of just over 3% over the past 15 years. And though the past 10 years or so have been tough for equities of all types, these long-term results demonstrate that emerging markets bond funds can deliver strong absolute returns and can outpace their equity rivals over extended periods of time.
To sum up...
Emerging markets bond funds aren't for everyone, but they deserve more
attention. Like their emerging markets equity counterparts, they are
great diversifiers and have big upside potential. Emerging markets
equity funds may produce somewhat bigger gains over long-term horizons,
but emerging markets bond funds shouldn't be too far behind them. And
they should be significantly less volatile along the way, which makes
them worth serious consideration from risk-conscious investors.
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