iShares JPMorgan EM Lcl Govt Bd ETF$Dist (LSE:IEML) - ETF price


ETF Report

iShares J.P. Morgan EM Local Govt Bond UCITS ETF USD (Dist) IEML

AnalystReport

PortfolioConstruction

The JP Morgan GBI-EM Global Diversified 10% Cap 1% Floor measures the performance of local-currency-denominated bonds issued by emerging market governments and public agencies. (Note--from inception until July 2017, this ETF tracked the Barclays EM Local Currency Core Government Bond Index.) JP Morgan Diversified benchmarks use only a limited portion of a country's current face amount outstanding for calculating weights. As an additional layer of control, the index this ETF tracks applies a 10% cap and a 1% floor to ensure wider diversification amongst the universe of eligible issuers. Bonds must have a minimum amount outstanding of $1 billion for local issues or $500 million for global issues, and at the time of inclusion must have a minimum remaining time to maturity of 13 months. The index does not apply credit rating requirements of restrictions, thus meaning that it also covers non-investment-grade-rated issuers. The index is rebalanced monthly. Intramonth coupon income is held as cash and reinvested at rebalancing.

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Fees

The annual ongoing charge for this ETF is 0.50%. ETFs providing standard market-cap-weighted exposure to local-currency emerging-markets government-bond market come with ongoing charges in the 0.50%-0.60% range. Investors can now find cheaper passive exposure to this market with traditional index mutual funds. In any case, 0.50% is competitive in the context of its Morningstar Category, where the in-house calculated median clean share class ongoing charge stands around 0.89%. Additional costs potentially borne by investors and not included in the ongoing charge include bid/offer spreads and brokerage fees when buy/sell orders are placed for ETF shares. There are also rebalancing costs whenever the index changes composition.

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FundConstruction

IShares uses physical replication to track the performance of the JP Morgan GBI-EM Global Diversified 10% Cap 1% Floor Index. This ETF distributes dividends on a semiannual basis. IShares uses stratified sampling to construct the fund. The index is broken down into sections, each representing key risk factors, such as duration, currency, country, rating, and sector. The managers then choose bonds included in the index that mimic the risk profile of each section. The aggregate result is a portfolio that represents the index's overall risk profile, while allowing the ETF manager to avoid purchasing bonds that suffer from illiquidity. IShares engages in securities lending with the holdings of the ETF. BlackRock acts as investment manager on behalf of iShares. The ETF can lend out up to 100% of net asset value. The average on loan for this ETF in 2018 was just 5%, for an annualised return of 2 basis points. Lending operations are backed by taking UCITS-approved collateral greater than the loan value and by revaluing loans and collateral daily. The collateral is held in a ringfenced account by a third-party custodian. The degree of overcollateralisation is a function of the assets provided as collateral but typically ranges from 102.5% to 112%. Lending revenue is split 62.5/37.5 between the ETF and BlackRock, respectively.

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Suitability

The case for a passive approach to investing in local-currency-denominated emerging-markets government debt looks compelling, and this iShares ETF stands as interesting investment option, particularly so since it switched to its new index in July 2017. It retains a Morningstar Analyst of Silver.

Compared with their developed counterparts, emerging-markets bonds are riskier, typically more illiquid and with higher transaction costs. Also, investors are advised not to see this as a homogeneous asset class and instead discriminate between countries. In addition, a local currency emerging-markets debt mandate has a layer of risk via the multiple currency lines at play.

On paper, this would support an active approach to the asset class, as active managers might be able to pick the right bets in terms of country exposure. However, this is an asset class fraught with difficulties and a geographical broad-based and low-cost passive approach can help deliver a more stable risk-return profile over the long-term.

Since July 2017, the ETF tracks the JP Morgan EM GBI-EM Global Diversified 10% Cap 1% Floor. Compared with the index that it tracked until then, the JP Morgan benchmark provides more diversification. It encompasses a larger number of issuing countries while capping exposure to 10% to avoid single country concentration. This places the fund on even keel to other highly rated peers.

Well-diversified passive funds have fared well in the context of its Morningstar Category, which includes both passive and active funds. Our positive take since the change of benchmark, together with a competitive ongoing charge of 0.50%, makes us confident on the fund’s ability to deliver risk-adjusted returns in excess of the category average over the long-term.

We have a positive view of the portfolio management team at the helm of iShares passive funds. The objective of the management process is not just to ensure tight tracking, but to add value where possible via the minimisation of trading costs.

The ETF retains a Morningstar Analyst Rating of Silver.

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Fundamental View

Emerging markets are routinely highlighted as one of the main economic success stories of the past three decades. Structural changes to the way these economies are governed have made emerging-markets bond exposure part and parcel of most investment portfolios, with investors lured by higher yields relative to developed counterparts.

Historically, emerging-markets government debt was mostly issued in U.S. dollars to make it palatable to global investors. However, changes in attitudes have allowed for the rapid growth of local-currency emerging-markets debt markets. Issuance in local currency helps governments to avoid currency mismatches in their domestic budgets.

The attractive yield differential remains a powerful driver of demand for emerging-markets bonds. In addition, investors in local currency may also benefit from a boost in returns at times of favourable foreign-exchange dynamics--that is, whenever emerging-markets currencies appreciate.

Many emerging-markets countries are now transitioning toward a new economic model that focuses on internal sources of growth rather than on exports to developed countries. This transition is difficult and not all countries have a diversified economy to achieve it. This may lead to comparatively lower economic growth rates going forward.

Irrespective of whether bond issuance in conducted in hard or local currency, investors in emerging markets need to keep a close eye on developments in the foreign-exchange market. Overall, the policy normalisation undertaken by the U.S. Federal Reserve is supportive of the U.S. dollar.

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Alternatives

There are several ETFs providing exposure to local-currency-denominated emerging-markets bonds. However, they all track different benchmarks, and this results in varying levels of coverage of the underlying market.

The most popular alternative to this iShares ETF, as measured in terms of assets under management, is SPDR Barclays Emerging Markets Local Currency Government Bond ETF (physical, ongoing charge 0.55%). It tracks the Barclays Emerging Markets Local Currency Liquid Government Index, which only includes bonds with minimum outstanding equivalent to USD 1 billion.

Investors can also consider ETFs that track fundamental-weighted benchmarks. PIMCO Emerging Markets Advantage Local Currency Bond Source ETF (physical; 0.60%) and ETFS Lombard Odier IM Emerging Market Local Government Bond Fundamental ETF (physical; 0.56%) track indexes that apply macro filters to overweight emerging-markets countries deemed to be best placed to pay back their debts.

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