Investing in Emerging Markets

Equities or Debt: Which Has More Upside Today?

Investing in Emerging Markets
September 15, 2014

Emerging market investments can fill a niche in the more speculative component of your investment portfolio. Just as in the US, you can invest in equities (stocks) or the debt (bonds) of emerging markets. The difference within emerging markets is that debt is not necessarily a lower risk investment – ask anybody who holds Argentinian bonds right now.

So which is the best choice for you? It is not a simple call.

Emerging market stocks have been particularly hard to call over the past few years. 2013 saw a significant gap form as the U.S. stock market headed toward record territory while emerging market stocks generally sank. Investors pulled out of emerging markets – over $15 billion from November 2013 through January 2014 according to Thomson Reuters – only to miss an impressive turnaround. While the S&P 500 rose 9.4% from February through July, the MCSI Emerging Market Index gained 15.7% over the same time period.

Are you late to the emerging market equity party? Not necessarily. With relatively low valuations and decent growth forecasts, emerging market equities are still the preferred pick of some analysts.

San-Francisco-based Nathan Rowader, Forward Management, LLC's director of investments, points out that there is an unusually large spread between the price-earnings multiples of emerging market equities and U.S. equities. U.S. stocks are at 18.4 while emerging stocks are at 13.4, creating a spread that is twice the past five years' average.

One general concern that all analysts have is the level of geopolitical unrest. In the words of Walter Hellwig, Senior V.P. at BB&T Wealth Management, "Anytime there's a threat of a shooting war, it produces weakness in equities."

The tensions between Russia and Ukraine make both equities and bonds difficult to predict, as quite a few emerging market funds have Russian holdings. Add the collective unrest in the Middle East and growing concerns about an Ebola pandemic in Africa, and you have a market that could face significant, albeit hopefully temporary, setbacks.

Meanwhile, the bonds of emerging markets are increasingly moving toward the investment grade status and lower risk profile of developed market bonds as the debt-to-GDP ratio of developed nations starts to surpass that of emerging markets.

Yields have not yet caught up, which means investors in emerging market bonds are getting higher coupon rates that are disproportionate to the risk involved. Savvy fund managers are taking advantage of this phenomenon. As a result, over half of the U.S.-traded ETF's in the Emerging Market Bond category at ETF Database (etfdb.com) have YTD returns greater than 4%, with a high of 7.85%. US Aggregate Bond ETFs are around 3%.

All bond investments — whether domestic or foreign — carry interest rate risk. This means that if interest rates move up on comparable bonds (i.e., equivalent term and credit quality) after you purchase yours, the market value of your bonds will fall. (The opposite is also true; if interest rates subsequently fall, your bonds will increase in value.)

With all foreign-denominated bonds — whether in developed or emerging markets — there is one additional risk you must consider: currency risk. If your interest and principal payments are made in a foreign currency, then you are exposed to fluctuations in the value of that currency relative to the US dollar. It is possible to remove this currency risk by purchasing a currency hedge alongside your foreign bonds. The cost of this hedge, of course, will reduce any investment gain you realize.

At the moment, both equities and bonds present opportunity to investors. It largely depends on whether or not you have the stomach for the volatility of emerging market equities.

As Jeff Shen, the emerging market leader at Blackrock's San Francisco office noted, "It's very difficult for a human being to tolerate 25% volatility in any asset class." Yet, if you are going to benefit from emerging markets, it is important to stay in it for the long haul.

Either diversify within your emerging market holdings by investing in broad-based equity and bond funds like iShares MSCI Emerging Market ETF (NYSEARCA: EEM) and iShares Emerging Markets Local Currency Bond ETF (NYSEARCA: LEMB) and stick with it, or pick your own based on your analysis of the holdings and prepare for a bumpy ride.

Whether you choose the rough or smooth ride, the real trick is not to panic and get off the rollercoaster early; although that may be difficult to pull off at the theme park, it is pretty good advice for emerging markets.

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