Morningstar Magazine - August/September 2017 - 52

Strategies

Emerging-Markets Edge
Low-cost indexing has a lead in the
emerging-markets bond category.

BEST IDEAS: PASSIV E

Phillip Yoo

This article is adapted from the ETF's Morningstar
Global Fund Report dated May 22, 2017.
IShares JP Morgan USD Emerging Markets Bond
ETF EMB provides market-cap-weighted
exposure to U.S.-dollar-denominated, emergingmarkets government bonds with at least
two and a half years until maturity. This fund is
one of the lowest-cost options in the emergingmarkets bond Morningstar Category.
Emerging-markets bonds are a risky and illiquid
corner of the fixed-income market with
high transaction costs, which explains this fund's
moderate tracking error. That said, the fund
is representative of the opportunity set available
to its actively managed emerging-markets
government bond funds and offers a sizable cost
advantage, supporting a Morningstar Analyst
Rating of Bronze.

This fund's credit- and interest-rate-risk profiles
closely resemble those of actively managed
funds in its category, yet it costs less. The portfolio
allocates approximately 55% of its assets
to investment-grade bonds and the rest to
high-yield bonds. The split between the two is
roughly half and half for a typical fund
in the category. The fund's duration is longer than
the category average, but it offers a comparable
yield because it of its underweight in
sub-investment-grade credits.

emerging-markets bonds tend to offer higher
yields than their developed-markets counterparts.
Investing in a broad market-cap-weighted
bond index has a few advantages. The indexed
portfolio reflects the composition of the fixedincome market, replicating the collective views of
the market participants at a low cost. Also,
it reduces transaction costs by tilting toward the
largest and most-liquid issues. However,
there are some drawbacks. Market-cap weighting
skews the portfolio toward the mostindebted issuers, increasing credit risk while
decreasing diversification.

High trading costs have caused this fund's
performance to lag that of its index by an amount
greater than its expense ratio. From its launch
in December 2007 through March 2017, the fund
produced an annualized return of 6.45%,
trailing the benchmark by 80 basis points on an
annualized net of fee basis.
The fund has outperformed its peers on both an
absolute and risk-adjusted basis, however.
Its five-year annual return through March of 4.9%
was ahead of the category average by 1
full percentage point. Its risk-adjusted return,
measured by its Sharpe ratio, was also better than
the category average over the same period.
The fund's outperformance was principally
attributable its low cost. It is the fourth-lowest-cost
fund in the category.
Fundamental View

Emerging-markets bonds carry myriad risks,
including country, liquidity, and currency risks, in
addition to the usual fixed-income risks,
such as credit and interest-rate risk. Accordingly,

This fund has not kept up with its benchmark,
principally because of the illiquidity of the
underlying market. Trading costs for emergingmarkets government bonds, gauged by

IShares JP Morgan USD Emerging Markets Bond ETF EMB
Growth of $10K 06/30/2017

Stats 06/30/2017

12K
11.45 $
11
10.56

iShares JP Morgan
Em Mkts Bond ETF

10
The emerging-markets bond market does not
have the abundance of active market participants
that the U.S. bond market enjoys. Consequently,
these bonds are less liquid and costlier to trade.

Morningstar August/September 2017

In this case, currency risk is off the table
as the fund invests only in U.S.- dollardenominated bonds. Its portfolio is slightly more
conservative than the category norm, as it
has less exposure to high-yield bonds. Its country
allocation is similar to the category average.
Its three largest country positions are Indonesia,
Mexico, and Turkey, which combine to
make up one fifth of the fund's assets. On average,
the average fund in the category has 15%
of its assets invested in bonds from these three
nations. The fund's duration profile is slightly more
aggressive than its peers', which explains
why it has a comparable yield despite taking less
credit risk.

Morningstar Em
Mkts Bond AW

07/2014

07/2015

07/2016

9
8

Morningstar Category

Emerging Mkts Bnd

Inception Date

12/17/2007

Morningstar Analyst Rating

Expense Ratio

0.40%

3-Yr. Total Annual Return

4.55%

3-Yr. Total Rtn Category Rank

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