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Similar Funds Share Risks in Emerging Markets

NEW YORK (TheStreet) -- During the summer Van Eck launched the first emerging-market bond ETF denominated in local currencies with the Market Vectors Emerging Markets Local Currency Bond ETF (EMLC). Shortly thereafter came the WisdomTree Emerging Markets Local Debt Fund (ELD). While the names of the funds are almost identical, there is one potentially important distinction: The Market Vectors fund is an index fund tracking the J.P. Morgan GBI-EMG Core Index while the WisdomTree fund is actively managed by Mellon Capital Management.

While two months of side-by-side trade is far too soon to draw a definitive conclusion, the actively managed WisdomTree fund has offered the smoother ride versus the Market Vectors fund. Smoother is not necessarily better; some investors might prefer more volatility. And, again, while it is too early to know whether this stands up, anyone interested in the space should continue to watch this dynamic.

Mexico Bicentennial
Mexico, which just celebrated its bicentennial, is among the major holdings in two emerging-market ETFs.

At the moment there are differences between the two funds, but they are not dramatic. The WisdomTree fund allocates about 11% each to Indonesia, Brazil, Mexico and Malaysia, 7% each to Poland, South Korea, Thailand and Turkey and just under 4% to Chile, the Philippines, Colombia, Peru and Russia. The weightings represent tranches of fiscal responsibility as perceived by the managers of the fund. This distinction serves to be important, as the Market Vectors fund weights countries by "traditional market cap weighting," which for bond ETFs means the more debt issued by the country, the larger the weighting in the fund. This is only likely to be very important during times of extreme market activity -- and even then maybe not.

The biggest difference in country allocations is that the Market Vectors fund allocates 6% to Hungary and 3% to Egypt. Given the events in Hungary over the past few years, exposure to the forint -- the Hungarian currency -- could be a large source of the extra volatility. It dropped 70% against the greenback from July 2008 to March of last year.

Many of the other stats of the fund are similar as well. Both funds yield just under 5% and have average maturities near 6.5 years, but the Market Vectors fund is cheaper -- 0.49% versus 0.55%.

The case for investing in this space is simple to understand. Many of the countries in the funds are on firmer economic footing, having had debt crises in their pasts -- Russia in 1998 and Latin American countries at various times. Additionally, many of the countries (Brazil, Peru and Chile, for example) sit atop things the world must have, creating a tailwind for growth for these countries and visibility for ongoing fiscal responsibility.

While that sounds good and makes a good and compelling case for buying into the space, emerging-market bonds are not without risk. As mentioned above, the dollar went up 70% against the Hungarian forint during the worst nine months of the financial crisis. In roughly that same time the dollar went up 50% against the Brazilian real and 45% against the Turkish lira. Many of the currencies hardest hit by the crisis, whether justified or not, have rebounded (less so with the forint). But some sort of next shoe to drop in this or perhaps another financial event could have the same impact as in late 2008, meaning it would hit these funds very hard. This is not so much a prediction as an understanding of how quickly currencies can drop during a complete meltdown.

With the risk somewhat defined, either fund has a moderate place in a diversified portfolio in which buying individual issues from some of these countries is not an option. The funds create access, which is one of the benefits to the exchange-traded products industry.

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At the time of publication, Roger Nusbaum had no positions in the securities mentioned.

Roger Nusbaum is a portfolio manager with Your Source Financial of Phoenix, and the author of Random Roger's Big Picture Blog. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Nusbaum appreciates your feedback; click here to send him an email.

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