The other day I mentioned that PowerShares would soon launch an exchange-traded fund that invests in emerging markets, and before the virtual ink could dry, it did.
The PowerShares Emerging Market Sovereign Debt Portfolio ( PCY) debuted Oct. 11. I believe it offers a way to invest in emerging market bonds with potentially less volatility than closed-end funds. There are a number of closed-end funds that invest in emerging market bonds, but their share prices tend to drop below their net asset values during times of market crisis. That's because closed-end funds issue a fixed number of shares. When the assets they invest in are out of favor, their shares can sell off faster than the underlying securities. But ETFs can issue new shares to meet demand or dissolve existing shares into their component securities. This means they rarely deviate from their net asset values by significant amounts or for any length of time. The word "sovereign" means that PCY will own only government debt, no corporates. It looks to be a concentrated fund. It has only 25 holdings, most of the countries in which it has exposure appear to be very high-yielding, and there is a hint of active management. The index that underlies the fund, which is from Deutsche Bank ( DB), selects and weights 17 countries via a proprietary process and then rescreens for the 17 countries every year.
While there is a "secret sauce" element to why a particular country makes the cut, you can see from its holdings that that index is not very restricted. The largest country weights go to South Africa, Peru, Ukraine, Uruguay, Bulgaria, Vietnam and El Salvador. In the rest of the fund you find the usual suspects like Turkey, Brazil and Mexico. But an odd choice is the 4.85% allocated to Venezuela. Although unlikely, it wouldn't be the biggest shock ever if Venezuela canceled its bonds. Morocco (not in the fund) just canceled some of its debt due to drought conditions. Emerging market bonds usually have a very low correlation to U.S. equities. They also offer the potential for bigger moves than domestic bonds, because the economies of these countries are more volatile and occasionally subject to ratings changes. After contacting PowerShares by phone, I learned that a back test of the underlying index has a 0.234 correlation to the S&P 500 over the past five years. If that stands up, the fund should make a good diversifier. I have written a few times over my two years with TheStreet.com that I believe the dollar will continue to weaken over time against many currencies, including emerging markets like the ones in this fund. PCY would stand to get a tailwind if my not-too-unique thoughts about the U.S. currency turn out to be correct. I noticed one quirk in the holdings: a 3.2% weight in a bond from Panama. Panama uses the U.S. dollar as its currency; I asked about this on that same phone call and was told that all of the bonds in the fund are denominated in dollars. This is disappointing for anyone looking for a pure play on emerging markets, but PowerShares says investing in dollar-denominated bonds should help keep PCY liquid. The fund can buy more bonds if investor demand necessitates more shares being created. That's a possibility, given that the fund was only seeded with $5 million and it is the only product in this space for now.
The yield on this baby looks like it will be high but not that high; the index has a yield of 6.49%, which works out to 5.99% after the 50-basis-point fee. Obviously, that could change in the future. From the top down, this is an asset class that merits consideration for a diversified portfolio. As I mentioned above, there are many closed-end funds that do the job, but the big draws of the ETF structure, in addition to the potential for lower volatility, is that you always know what the fund owns. For example, one country you might expect PCY to have exposure to that it doesn't is Hungary. Hungary has some bigger problems than some other emerging markets. Knowing this, and knowing that PCY doesn't invest in Hungary while some closed-end emerging markets do -- or have reported doing so in the past -- might be an important consideration when selecting a fund. This could apply to another country you have a strong opinion about. To see exactly what PCY holds, click here . Anyone looking to diversify a portfolio, as opposed to making a short-term bet, would probably give a very small weight to the fund in his or her portfolio. For example, someone with 70% in stocks and 30% in bonds might allocate only 10% of their bond exposure, or 3% of overall exposure, to emerging markets. While that may sound low, keep in mind you are adding volatility into your bond portfolio with emerging markets. The difference between a good diversifier and a big bet is very distinct.