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iShares Competes in Emerging-Market Bond ETFs

Despite the similarities, PowerShares' offering has more going for it.

PowerShares was the first to list an emerging-market bond ETF, the Emerging Market Sovereign Debt Portfolio (PCY) - Get Report, earlier this year. Now there is some competition: the iShares JPMorgan USD Emerging Markets Bond Fund (EMB) - Get Report.

A little competition and choice is always a good thing where funds are concerned.

As a philosophical matter, I believe in constructing a portfolio with the attributes that EMB and PCY offer (low correlation, equity-like returns and decent yield), because over time the result should be a smoother ride to a very similar result. But in trying to choose between the two, I give the nod to PCY.

Like PCY, EMB holds dollar-denominated bonds, so holders are neither hurt nor helped by currency fluctuations.

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EMB also has a relatively small number of holdings, at 35; although it's not quite as small as PCY's 25 holdings.

It's important to understand that both ETFs hold fewer bonds than their underlying indices. In the case of EMB, its underlying index has 112 issues in total. Having this flexibility will make it easier to create new shares of the fund, which of course would entail buying more bonds.

Both PowerShares and iShares can shop around a little and choose the best bonds available, on the basis of the prevailing market condition at the time. They're not forced to buy the same paper every single time it wants to create new ETF shares, regardless of how scarce it might be. Still, either fund could be disadvantaged if a bond dealer knows the fund has to buy a specific bond.

One drawback to EMB is that, despite having more holdings than PCY, it provides exposure to only 10 countries, as opposed to 17. The drawback of investing in only 10 countries is that each country has more potential influence on the fund's performance.

For example, EMB allocates 8% of assets to Venezuela. It's not hard to imagine some sort of political event jeopardizing that country's sovereign debt. By comparison, PCY allocates just under 5% to Venezuela.

Like PCY, EMB is going for yield. This is obvious from the country list, which if you don't know has only one low-yielding country: Malaysia. iShares lists EMB's yield to maturity at 6.34%. The tilt to higher-yielding markets wouldn't be a constant threat to the fund's performance, but every so often market events come along that will affect it -- and PCY too for that matter.

However, it stands to reason that the ETF structure offers a safer way to invest in emerging-market bonds than closed-end funds. Closed-end funds issue a fixed number of shares, and during a market crisis or dislocation, they can sell off faster than their holdings. That's generally not a problem with ETFs, since their shares can be liquidated when demand falls off, supporting their prices.

However, it should be noted that there have been a couple of ETFs that, for much different reasons, have traded at large discounts or premiums to their net asset value.

There is one composition quirk to EMB (which I was told by iShares is not a mistake): The fund's largest holding is a 30-year bond from Russia which has a 7.59% weight in the fund. By comparison, the second-largest holding only has a 2.16% weighting. The explanation iShares provided, that it had something to do with liquidity, the size of the issue and the attractiveness of the bond, was unclear and, candidly, sounded like a guess.

It's unlikely Russia would default for a second time in the next decade or two, but if anything happens to that one security, the fund will suffer.

Some of the other details are that EMB's expense ratio is 0.60%, compared with 0.50% for PCY; the average credit rating of its holdings is BB-plus from Standard & Poor's; the weighted average maturity is 15.44 years; and the weighted average effective duration is 7.90 years. This means the fund does not own short-dated paper such as T-bills and could move around lot, relative to a bond fund, if volatility in the global bond market increases.

As I mentioned in my

previous story about PCY in October, a fund like this provides access to an asset class with close to equity-like returns (the back-test provided by iShares beat the

S&P 500

for the past five and 10 years, but trails for the past one and three years) with little or no correlation to U.S. stocks.

There is no information available about EMB's correlation to the stock market in the iShares literature, but PCY has had a negative correlation with the S&P since it was launched, and I would expect EMB's performance to be close to that.

At the time of publication, Nusbaum had no positions in any of the securities discussed in this article, although positions may change at any time.

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;

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