Jeremy Landau's analysis of the emerging debt market, terra incognita for ETFs

Source: Bloomberg and IVO Capital Partners. Emerging Markets Bond ETFs are comprised of the top 20 sector ETFs listed on page 3. Average returns and expense ratios are market-cap-weighted averages for ETFs and fund-size-weighted averages for active emerging market debt managers. Active emerging market debt managers are primarily corporate debt funds and include: Abrdn SICAV I - Emerging Markets Corporate Bond Fund, Aviva Investors Emerging Markets Corporate Bond Fund, BlackRock Global Funds - Emerging Markets Corporate Bond, Edmond de Rothschild Fund - Emerging Credit Fund, Goldman Sachs Emerging Markets Corporate Bond Portfolio, JPMorgan Funds - Emerging Markets Corporate Bond Fund, Ninety One Global Strategy Fund - Emerging Markets Corporate Debt Fund, Pictet - Emerging Corporate Bonds, Vontobel Fund - Emerging Markets Corporate Bond and IVO Emerging Markets Corporate Debt. Data as of January 16, 2025.

At IVO Capital Partners, as an asset manager specializing in EM debt, we observe an interesting dynamic: while this asset class continues to attract investors who favor an active management approach, the initial appeal of ETFs compared to active strategies remains strong for investors who are new to the field or looking for alternatives to participate. In principle, ETFs are designed to offer low-cost exposure to specific asset classes. While their benefits may seem attractive at first glance, these instruments come with significant trade-offs, particularly in the fixed income space and more specifically in emerging market debt.

Our in-depth analysis of passive and active EM debt ETFs reveals that these vehicles often fail to achieve their stated objectives, making them less effective than actively managed funds for investors seeking access to emerging debt markets.

In this note, we highlight the main limitations of EM debt ETFs (focusing mainly on passive ETFs, as active ETFs represent only a small segment of the market) and present evidence supporting our view that they are not an adequate tool to efficiently access the emerging market debt market. Furthermore, we demonstrate why active management, which is at the heart of IVO Capital Partners’ investment approach, remains a highly effective strategy to generate alpha compared to ETFs, particularly in complex and specialized asset classes.

ETFs emerged in the 1990s and were designed to combine the diversification benefits of mutual funds with the tradability of stocks, while providing low-cost access to various asset classes. This financial innovation quickly gained popularity. According to Morningstar , the global ETF market is now valued at approximately $12 trillion (2024).

Initially focused on stocks, the market expanded in the early 2000s to include bond ETFs, which are estimated to have $1.7 trillion in net assets as of the end of 2024. These products have transformed bond investing by providing transparent, liquid, and cost-effective access to diversified bond portfolios. These ETFs appeal to investors seeking income, stability, and flexibility. Morningstar reports that in the U.S. alone, ETFs and passive strategies accounted for 60% of third-party equity assets in 2024, up from just 20% in 2011.

However, despite their advertised benefits, bond ETFs have struggled to capture a larger market share, consistently accounting for only a fifth of total ETF assets under management. Furthermore, in emerging market debt, ETFs accounted for just 2.5% of the overall market size, estimated by Goldman Sachs at around $1.2 trillion (excluding EM local sovereign bonds, which are now a $7 trillion asset class).

Source: Morningstar. Data as of December 31, 2024.

The lack of investor interest is reflected in the current limited and insufficient supply of emerging market debt ETFs (see Figure 2). Around 50% of EM debt ETF assets under management are concentrated in a single vehicle. The top 5 ETFs (each managing over $1 billion) charge what we consider relatively high fees, ranging from 20 to 50 basis points, and are primarily focused on sovereign debt. Active EM debt ETFs represent only 2% of total assets, or around $600 million. Their limited adoption is due to several factors, including higher fees (on average 0.64%) and wider bid/ask spreads, reaching almost 0.75%, compared to less than 0.1% for the largest passive ETFs.

Source: Bloomberg, JP Morgan and IVO Capital Partners. Data as of December 31, 2024.

Source: Bloomberg, JP Morgan and IVO Capital Partners. Data as of December 31, 2024.

As mentioned earlier, since their introduction in the early 2000s, the limited interest in fixed income ETFs, particularly in emerging market (EM) debt, highlights the persistent structural disadvantages of these financial instruments to access this specific market. These limitations, such as restricted investment flexibility and relatively low risk-adjusted return potential, hamper their ability to fully exploit market opportunities and outperform active managers:

Passive ETFs, which represent the vast majority of EM debt ETFs, hold bonds without active analysis or risk assessment, typically holding a bond until it defaults. The main factor determining an issuer’s weight in an index is its size, although there is no strong correlation between a company’s size and its default risk.

A notable example in emerging markets is Chinese property developer Evergrande. In 2020, Evergrande was one of the largest issuers of US dollar debt in the world, but it ultimately defaulted. This illustrates that large weightings in indices can be exposed to default risk, highlighting why ETFs may not be suitable for the credit asset class.

This contrasts sharply with equities, where markets have increasingly adopted a “winner-takes-all” logic, with large weights in indices often representing the best performances. In emerging market credit, there is no such trend. On the contrary, a high-yield issuer with increasing debt year after year is often a warning signal, as the case of Evergrande with its $100 billion of debt shows.

This fundamental difference is one reason why we believe ETFs are not suited to our asset class, where deep credit analysis and active risk management are essential to navigate risks and identify attractive investment opportunities.

A notable example is Taiwan Semiconductor Manufacturing Company (TSMC), the largest holding in the JP Morgan CEMBI BD Index (2.57%). Located in Taiwan, this company currently offers an average spread of less than 50 basis points over US Treasuries. After factoring in ETF fees, the yield is equivalent to that of Treasuries, providing little to no added value. Additionally, TSMC is one of the highest-rated companies in the index, but it carries significant geopolitical risk.

This situation recalls lessons learned from past events in this asset class. For example, at the end of 2021, Russian issuers accounted for about 2.5% of the CEMBI BD index, with an average spread of 253 basis points, lower than the index average of 318 basis points at the time. Following the war and sanctions, Russian bonds were removed from the index with a zero valuation, resulting in significant losses for ETF investors.

In contrast, our flagship fund, the IVO EM Corporate Debt Fund, had no exposure to Russia, as we assessed the risk-return profile and determined that it offered limited upside while presenting significant risks. This ability to exercise geographic flexibility is, we believe, essential to creating additional value and effectively navigating today’s heightened geopolitical uncertainties — particularly in light of changing global dynamics, such as the return of Donald Trump to the U.S. presidency.

Another potential source of alpha that ETFs miss is the “new issue premium” available in the primary bond market, which is accessible only to active managers. ETFs cannot participate in primary markets, where newly issued bonds or debt securities are sold directly by issuers. This limitation prevents ETFs from integrating the newest and potentially attractive investment opportunities into their portfolios.

New primary issues often offer attractive investments due to the “new issue premium,” which can include higher yields, better terms, or improved credit profiles compared to existing bonds. By not having access to these opportunities, emerging market debt ETFs forgo the opportunity to capture these potentially higher yields, resulting in suboptimal portfolio performance.

IVO Capital Partners’ funds, on the other hand, actively participate in the primary market, taking advantage of new investment opportunities while strengthening existing portfolio positions. Our investment team conducts continuous reviews of new primary issues, both from established and emerging issuers. In addition to our strong and long-standing relationships with issuing banks, the size of our funds, including IVO EM Corporate Debt , with €800 million of outstandings, allows us to obtain preferred allocations on new issues at attractive prices, offering upside potential. This strategic advantage allows us to generate alpha and deliver superior performance.

The creation and redemption process, which is central to the operation of ETFs and essential to align their market price with their net asset value (NAV), is fundamentally unsuitable for accessing fixed income markets, particularly emerging market corporate debt (see Appendix A). This is due to the lower liquidity, reduced efficiency and increased fragmentation of these markets.

Unlike equities, where each issuer is represented by a single principal security, bond markets include multiple instruments per issuer. For example, the JP Morgan CEMBI BD index includes approximately 750 issuers, but over 1,800 securities. This fragmentation can have a significant impact on liquidity, particularly in times of market stress.

While mutual fund investors can trade at NAV on a daily basis, ETF investors can face significant discounts. Bloomberg reported that during the COVID-19 crisis, bond ETFs have traded at dramatic discounts to their NAV, in what some have called a “liquidity death loop”: in 2020, about 70 bond ETFs traded at discounts exceeding 5% of their NAV, and 16 had discounts exceeding 10%. This highlights the significant costs of seeking liquidity during times of crisis and market dysfunction.

Disappointing performance confirms ETFs' shortcomings in accessing emerging market debt markets

Due to the key structural constraints mentioned above, emerging market debt ETFs have consistently underperformed both their benchmarks and active managers specializing in EM debt over the long term.

Source: Bloomberg and IVO Capital Partners. Emerging Markets Bond ETFs are comprised of the top 20 sector ETFs listed on page 3. Average yields and expense ratios are market capitalization-weighted averages. The Bloomberg Emerging Markets Hard Currency Aggregate Index is a leading benchmark for emerging market hard currency bonds, including USD-denominated bonds issued by emerging market sovereign, quasi-sovereign and corporate issuers. The Bloomberg EM USD Aggregate: Sovereign Index tracks fixed and floating rate US dollar-denominated bonds issued by emerging market governments. Data as of January 16, 2025.

ETFs were originally designed to provide investors with low-cost access to specific asset classes, with the aim of closely replicating the returns of their underlying assets. However, as Figure 4 shows, emerging market debt ETFs have failed to deliver on this promise. Over multiple periods, they have consistently underperformed their EM bond benchmarks, calling into question their effectiveness in delivering benchmark-like economic returns.

Source: Bloomberg and IVO Capital Partners. Emerging Markets Bond ETFs are comprised of the top 20 sector ETFs listed on page 3. Average returns and expense ratios are market-cap-weighted averages for ETFs and fund-size-weighted averages for active emerging market debt managers. Active emerging market debt managers are primarily corporate debt funds and include: Abrdn SICAV I - Emerging Markets Corporate Bond Fund, Aviva Investors Emerging Markets Corporate Bond Fund, BlackRock Global Funds - Emerging Markets Corporate Bond, Edmond de Rothschild Fund - Emerging Credit Fund, Goldman Sachs Emerging Markets Corporate Bond Portfolio, JPMorgan Funds - Emerging Markets Corporate Bond Fund, Ninety One Global Strategy Fund - Emerging Markets Corporate Debt Fund, Pictet - Emerging Corporate Bonds, Vontobel Fund - Emerging Markets Corporate Bond and IVO Emerging Markets Corporate Debt. Data as of January 16, 2025.

One of the main arguments in favor of ETFs for investors is their cost-effectiveness. According to our analysis, the average expense ratio for all emerging market debt ETFs, whether passive or active, is 35 basis points, compared to 80 basis points for active EM debt funds. While ETFs are generally (slightly) less expensive, this cost advantage becomes negligible when looking at the historical returns of active managers.

As Figure 5 illustrates, active EM debt managers, including the IVO EM Corporate Debt fund, have consistently outperformed ETFs over multiple periods. Over a five-year period, the average EM debt ETF investor would have saved 65 basis points per year in fees compared to our IVO fund, but would have lost 25% in cumulative performance. This consistent outperformance clearly shows that the cost savings offered by ETFs do not offset the value generated by active management with higher fees.

While ETFs have gained popularity as a cost-effective way to access various asset classes, such as equities, they have struggled to gain traction in the fixed income market due to significant structural flaws. Our in-depth analysis of the EM debt ETF market reveals that these vehicles, whether passive or active, are poorly suited to navigate less liquid, less efficient and more complex markets such as emerging market debt.

Their promise of lower costs does not compensate for their consistent underperformance compared to benchmarks and comparable active managers. Moreover, ETFs have notable disadvantages compared to actively managed funds, such as the IVO EM Corporate Debt Fund. By leveraging our experienced investment team, a robust fundamental research framework, deep local expertise, advanced analytical tools and active risk management, we are better equipped to manage risk, exploit investment opportunities and generate alpha in EM debt markets.

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Understanding the trading mechanism of ETFs is essential, as there are notable limitations regarding bond ETFs, particularly those involving less liquid securities, such as emerging market corporate bonds.

At the heart of how an ETF works is the creation/redemption process, a mechanism designed to align the market price of the ETF with its net asset value (see Chart 6 below). This process involves Authorised Participants (APs) – large financial institutions such as Citadel Securities, Jane Street and Flow Traders – who act as an intermediary. In the creation process, APs provide the issuer with a basket of bonds reflecting the ETF’s assets in exchange for new ETF shares. These shares are then sold into the market to meet investor demand and prevent the price from rising above the NAV. Conversely, in the redemption process, APs purchase ETF shares from the market and return them to the issuer in exchange for the underlying bonds, reducing the supply of shares and bringing the price back into line with the NAV.

Source: IVO Capital and Financial Times.

Source: Flow Traders Data (2023).

This process, typically done in-kind (using securities rather than cash), improves liquidity and helps minimize costs, even in less liquid bond markets. However, the liquidity of the underlying bonds remains a critical factor. Fixed income securities, particularly HY or emerging market bonds, often have lower liquidity, complicating the creation and redemption process. For example, bid-ask spreads on emerging market corporate bonds can exceed 2 points.

A key technical reason for the success of ETFs in equity markets and more liquid fixed income segments (such as government bond markets) is the widespread “electronification” of trading in these asset classes. As illustrated in Figure 7, the majority of trading in equity products and major government bonds is now done electronically.

In contrast, other segments of the credit markets, such as emerging market bonds, are still predominantly (90%) traded by voice or messaging. This manual trading process plays a crucial role, allowing human traders, within active managers, to better negotiate bid-ask spreads than those initially offered by brokers. Thus, the lack of electronic trading on emerging market bonds significantly hinders the automation of the ETF creation process, making it more complex, inefficient and slow.

As a result, ETFs that track indices composed of less liquid securities, such as emerging market corporate bonds, are subject to still-inefficient trading mechanisms and gaps between their NAV and their market price—inherent limitations already explored in this note.