http://www.nytimes.com/2014/10/12/business/mutfund/in-emerging-market-bonds-political-risk-is-a-constant.html 2014-10-10 21:56:39 In Emerging-Market Bonds, Political Risk Is a Constant Although emerging markets can be shaken by various kinds of events, many investors have been making room for the overall sector in their portfolios. === WHEN Argentina defaulted on its sovereign debt in July, investors seemed to shrug. Money kept flowing into Indeed, many investors have been making room in their portfolios for this asset class. They’ve piled into emerging-market bonds from a variety of countries, as new investment darlings like Mexico and Indonesia have overshadowed Argentina. “We consider emerging-market bonds as similar to high-yield debt — an in-between asset class” straddling stocks and bonds, said For the last several years, emerging-market bond mutual funds and E.T.F.s have offered better returns than developed-world debt. The emerging-market bond funds tracked by Morningstar returned an annualized average of 6.3 percent in the five years ended on Sept. 30, compared with an annualized average of 4.1 percent for the Barclays Capital U.S. Aggregate Bond Index. It’s important to recognize that those higher returns come with higher risks. “It’s like somebody trying to get a Emerging markets often have upheavals of a sort that developed countries rarely experience. There was Argentina’s failure to pay interest on its bonds this summer. And that may have been a minor event compared with Russia’s clashes with Ukraine, the warfare in the Middle East and the Such risks are a constant in emerging-market investing, said Michael J. Conelius, manager of the Just as emerging-market countries can sputter while the American economy chugs along, they also can surge when it sags. These varying trajectories can add diversification to a portfolio, said L. Bryan Carter, lead manager of the The long debate about the benefits of active versus passive portfolio management crackles in this sector, as in every corner in the investment business. Active managers say the greater risk and variety of emerging-market bonds bring opportunities for them to apply expertise and experience. “One reason that you might not want to use a passive strategy in emerging bonds is that all the countries aren’t created equal,” said Teresa Kong, manager of the An active manager can avoid troubled countries, while an indexed fund or E.T.F. must hew to the allocations of its underlying index. Even so, he said, the average active fund has not beaten the market averages lately. Only 13 percent of actively managed emerging-market bond funds bested the Barclays Emerging Markets USD Aggregate bond index for the three years ended on June 30. “It got better at five years — 36 percent,” he said. Besides replicating a market’s average return, index funds and E.T.F.s offer low costs and transparency because their holdings mirror their indexes, said Francis G. Rodilosso, senior investment officer and fixed-income portfolio manager for Still, some long-tenured active managers in the sector manage not only to top their benchmarks but also to do so without undue risk, according to some metrics. Consider the That does not mean Mr. Carlson, the fund’s manager since 1995, avoids big bets.  As of Aug. 31, Venezuelan bonds accounted for 11.4 percent of the fund, about twice the Morningstar category average. “We diversify across 75 countries, so we’re balancing the riskier credits like Venezuela against investment-grade ones like Mexico,” he said. HOW much of a portfolio should be allocated to emerging-market bonds? It depends on whom you ask, and on your risk tolerance. “If you’re going to be up all night checking the latest movement of troops in the Ukraine, the right amount is nothing,” Mr. Carlson said. For a less skittish investor with an investment horizon of at least three years, 6 percent to 10 percent of a total portfolio could make sense, he said. Karin S. Anderson, a senior analyst at Morningstar, says that if investors hold emerging bonds at all, the bonds should supplement, not replace, core holdings like Treasuries and investment-grade corporate bonds. “You should keep them in the supporting-player role — a satellite bucket in your portfolio,” she said. And investors should study a fund before jumping in, she said. Within the broad category of emerging-market bonds, managers can emphasize securities with varying levels of risk. Among the options are sovereign bonds denominated in dollars, sovereigns denominated in local currencies and emerging-market corporate bonds, typically denominated in dollars. An index fund or E.T.F. might own only one type of bond, but active managers will often juggle all three and might stash a little money in cash and stocks, and hedge currency risk with derivatives. Another caveat is that many funds have short records. “About half of the emerging-market debt funds sold in the U.S. are less than three years old,” Ms. Anderson said. An investor might not be able to see how a fund held up in 2008, when the average emerging-market bond fund lost 17.6 percent. “These do tend to be the most volatile of the bond funds,” she added.