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A smart beta ETF for emerging markets debt

Lombard Odier Investment Managers and ETF Securities have added to the range of London-listed emerging markets debt ETFs
September 3, 2015

Emerging markets debt has confounded critics by side-steping the recent market rout, and now a new exchange traded fund (ETF) has been designed to tap into the changing nature of this asset.

But commentators argue that smart beta ETFs (which rank stocks by anything other than market capitalisation) and bonds could be a trickier match than at first glance.

The ETFS Lombard Odier IM Emerging Markets Local Government Bond Fundamental GO UCITS ETF (LOCG) is the first ETF listed on the London Stock Exchange to weight its exposure to emerging markets bond issuers based on country fundamentals rather than their level of debt. The fund, which has a total expense ratio of 0.55 per cent, offers exposure to local currency debt and weights issuers by fundamental factors designed to assess credit worthiness in a bid to target the best-value bonds.

Many put emerging markets debts' recent resilience down to the fact that more issuers are borrowing in local currencies rather than taking on high exposure to expensive dollar-denominated debt, which makes them more vulnerable to market shocks. And those commentators argue that now is a good time to be looking selectively at high-yielding emerging markets debt.

Using ETFs to invest can also be a good way to avoid some of the liquidity issues associated with other funds: because ETFs trade on the stock market there is almost always a buy and sell price available for them, even when the underlying assets are fairly illiquid. However, fixed-income ETFs have been one of the most under-served ETF areas in the UK, particularly when it comes to the world of smart beta, despite the fact many see it as a good match.

But critics of the smart beta bond ETFs such as ETFS Lombard Odier's range point to their short track record and argue it is a research-based concept rather than proven theory. And fixed-income smart beta products also carry potentially higher transaction costs due to the illiquid nature of the underlying securities, which can be passed onto investors as trading costs.

Existing emerging markets local currency bond ETFs performance year to date

Local currency emerging market bond ETFs (GBP share class) Total return (YTD)
Pimco Emerging Markets Advantage Local Bond Index Source UCITS ETF-6.9
iShares Emerging Asia Local Government Bond UCITS ETF -7.2
iShares Emerging Markets Local Government Bond UCITS ETF-13.7
SPDR Barclays Emerging Markets Local Bond UCITS ETF -14
Lyxor Emerging Markets Local Currency Bond UCITS ETF -17.9

Source: Morningstar, as at 2 September 2015