Emerging Markets ETFs and Their Underlying Indexes – EMB, PCY, EEM, SCHE

With a rapidly growing rate of the economy, Emerging Markets become more and more attractive for investors nowadays. There are two ways to get the exposure from the flourishing EM, one is to invest in the debts issued in EM countries; the other is to put money into EM related equities, which can be further executed in two ways again: buy equities directly issued by the EM companies, or buy domestic stocks with a high correlated to EM performance. Accordingly, there are such aggregated investment vehicle/ETFs available: EMB, PCY are the representative debt products, while EEM and SCHE are the equity kind.

EMB, the iShares JPMorgan USD Emerging Markets Bond ETF, tracks JPMorgan EMBI Global Core Index, which is comprised of US-dollar-denominated sovereign debt issued by emerging-market countries with more than $1 billion outstanding and at least two years remaining in maturity. It was launched in December 2007 and has so far accumulated an AuM of $11.3 billion. EMB holds USD-denominated rather than local-currency debt. Therefore, investors don’t fall under currency fluctuation risk, but also forfeit the potential appreciation upside of foreign currencies. EMB offers a deep liquidity with average spread rate at 0.01%.

Referring to the index methodology, the instrument selection criteria are detailed as follows:

1) Issuer type classification; 2) Currency denomination; 3) Current face amount outstanding; 4) Remaining time until maturity; 5) Settlement method; 6) Quantifiable source of cash flow return, and 7) Quoted price availability

1) Issuer type classification: it contains only those bonds issued by sovereign and quasi-sovereign entities from index eligible countries. Issuers are classified as quasi-sovereign if the sovereign has explicitly guaranteed the issuer or is its majority shareholder.

2) Currency denomination: only those instruments denominated in U.S. dollars are considered for inclusion. Historically, the universe of emerging markets external debt has seen its liquid issues denominated in U.S. dollars. At a future date, non-U.S. dollar debt, specifically euro-denominated issues, will be reconsidered for inclusion in the EMBI Global.

3) Current face amount outstanding: the list is narrowed further by only considering issues with a current face amount outstanding of US$500 million or more. If an issue’s current face outstanding falls below this requirement – due to either a debt retirement by the sovereign or the amortization of principal – the issue will be removed from the index at the next month-end rebalancing date. The reverse also holds true. Existing issues that, through reopening, increase in size to satisfy our minimum current face outstanding requirement are then considered for inclusion in the EMBI Global.

4) Time until maturity: of the issues with at least a current face amount outstanding of US$500 million, only those instruments with at least 2½ years until maturity are considered for inclusion. Once added, an instrument may remain in the EMBI Global until 12 months before it matures. On the month-end preceding this anniversary, the instrument is removed from the EMBI Global.

5) Settlement method: Instruments in the EMBI Global must be able to settle internationally (either through Euroclear or another institution domiciled outside the issuing country).

6) The quantifiable source of cash flow return: J.P. Morgan reserves the right to exclude from the composition of the EMBI Global any debt instrument that it considers having a cash flow structure from which a verifiable daily return cannot be calculated.

7) Quoted price availability: the final requirement is that an issue’s bid and offer prices be available on a daily and timely basis – either from an interdealer broker or J.P. Morgan. The lack of availability of such prices prevents the addition of a new issue to the index. In the case of the current EMBI Global issues, if reliable prices for an issue become unavailable during a month, it is removed from the index at its next month-end rebalancing date. Once an issue is removed, it will not be reconsidered for inclusion in the index during the next 12 months.

Now take a look at PCY, PowerShares Emerging Markets Sovereign Debt Portfolio. PCY was issued to the market in October 2007, now has $4.4 billion AuM. It targets DB Emerging Market USD Liquid Balanced Index, and USD-denominated emerging market USD-denominated bonds with relative value screens. This index requires that the sovereign debt has at least 3 years to maturity. Additionally, there is more liquidity and relative value screens added, setting it apart from other USD-denominated funds. PCY maintains geographic diversity but favors longer maturities, hence, effectively bearing additional interest rate risk for higher yield.

Switching the gear to equity EM ETFs, iShares MSCI Emerging Markets ETF, EEM, is the largest one of this kind. It started in April 2003 and has since amassed a colossal $31.56 billion AuM. SCHE, Schwab Emerging Markets Equity ETF, issued 7 years later than EEM, followed with an AuM of $3.45 billion.

EEM targets MSCI Emerging Markets Index, while SCHE follows FTSE Emerging Markets Index. Let’s compare the nuances of these two EM indexes.

According to Calamos (http://www.calamos.com/~/media/FA/Documents/Products/MF/Papers/Evolving%20World%20Paper.aspx), the difference between these two Emerging Market Indexes are growing, particularly, in their varying ways to treat certain EM country stocks.

In late May 2015, FTSE Russell announced two new emerging markets indices that include China A-shares at an initial level of 5%. (China A-shares are traded on Shanghai and Shenzhen Stock Exchanges) On June 9, 2015, MSCI announced that it would NOT include China A-shares in its popular MSCI Emerging Markets Index. However, MSCI made clear its intention to move toward including A-shares over time.

Their treatment toward Korea also differs, starting in 2013; FTSE included South Korea in its list of developed economies—therefore removing it from its emerging markets indices. MSCI, on the other hand, continues to classify South Korea as “emerging markets”.

Other than the above caveats, the construction of EM indexes is fundamentally similar by both MSCI and FTSE. Using MSCI EM index to illustrate the construction.

1) The universe based on the constituent securities of the MSCI Emerging Markets Index except for Brazil, India, Mexico, and Russia. For these four markets, the selection universe is limited to American Depositary Receipts (ADRs) and Global Depositary Receipts (GDRs) listed in New York and London.

2) The constituents are subject to the liquidity requirements of the MSCI Global Investable Market Indices. For Brazilian, Indian, Mexican and Russian depositary receipts, similar liquidity filters are applied to ensure their investability. Specifically, a depositary receipt must have a 3-month Annualized Traded Value Ratio (ATVR) of at least 15%, a 12-month Annualized Traded Value Ratio (ATVR) of at least 15% and a 3-month frequency of trading of at least 80%. The depositary receipt must have started trading at least three months before the implementation of an index review.

3) Limited Investability Factors (LIFs) are applied in the MSCI Emerging Markets Index to securities with limited investability, for example in the case of low foreign room for foreign investors. Constituent securities of the MSCI Emerging Markets Index subject to a LIF are generally not eligible for the MSCI EM 50 Index. However, Brazilian, Indian, Mexican and Russian depositary receipts remain eligible for the MSCI EM 50 Index in case a LIF is applied due to the low foreign room to the underlying constituent securities in the MSCI Emerging Markets Index. In such case, the LIF is not applied to the depositary receipt in the MSCI EM 50 Index.

4) Country filters are applied in order to minimize the number of countries and currencies in the MSCI EM 50 Index. Only countries with more than three percent weight in the underlying MSCI Emerging Markets Index are included. Among the remaining countries, only countries with two or more securities ranking in the top 50 companies by free-float adjusted market capitalization are included.

I’d juxtapose all these four ETFs to observe and compare their past performance. Apparently, two bond ETFs – EMB and PCY display less volatility than that of the two equity ETFs – EEM and SCHE. Between EEM and SCHE, the two are highly correlated.

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