Hougan: ECON, Emerging Markets' New Face

Editor's note:Matt Hougan, IndexUniverse's global head of content, has had a ringside seat in the ETF industry for years. In this once-a-month feature, IU editors and writers sit down with him to share with our readers some of his thoughts and insights in the world of ETFs .

This month, Managing Editor Olly Ludwig caught up with Hougan for a chat about what to look forward to for the rest of 2013, specifically the outlook for fixed-income and emerging market ETFs-two of the worst-hit asset classes in June, as investors headed for the exits amid worries about rising interest rates. last time we spoke, you talked about the WisdomTree Japan Hedged Equity Fund (NYSEArca:DXJ) and Japan being the biggest surprise of 2013 so far. What do you think is likely to be the biggest surprise for the rest of the year?

Hougan: I'm not a market forecaster, so no one should pay attention to what I say. But I'm fairly dovish on the outlook for fixed income. I think the expectations that that market will fall off a cliff immediately are probably overblown. I think what will be surprising the remainder of the year is a generally bullish trend in equity markets.

In terms of the ETF space, there are a few things going on that I find extraordinarily interesting that I think will continue. One is that even though Pimco has lost assets in the Pimco Total Return ETF (NYSEArca:BOND)-and a lot of people have made a big deal out of that-they've gained huge flows into their short-term funds, be it the Pimco Enhanced Short Maturity Strategy ETF (NYSEArca:MINT) or their short-term bond strategy.

I think that suggests that a lot of the assets coming out of BOND are just shortening up on duration and staying within the Pimco family-a sort of brand loyalty in the bond space, which is interesting.

Those short-term, fixed-income products that give you an enhanced yield are a place investors and advisors want to be right now-that may be what the biggest surprise of the second half of the year will be:continued growth of the short-term, enhanced-yield products like MINT and like Pimco's short-term corporate bond ETF; like the short-term, high-yield muni stuff; and like the PowerShares Senior Loan Portfolio (NYSEArca:BKLN).'re talking about a general interest in holdings on the short end of the yield curve in the context of rising rates rather than, say, a new interest in alternative cash-equivalent proxies as it relates to what's going on with money market funds at the SEC right now?

Hougan: Yes, absolutely. I see fixed-income investors shortening up on their duration, but not doing it in a plain-vanilla way. The classic rotation would be out of long-term Treasurys and into short-term Treasurys. I don't see that happening so much as I do out of long-term Treasurys and into things with short duration, but with enhanced credit risk that can lead to higher yields.

It's a relatively easy conversation for advisors to have with their clients. They can sit down and say:"We're going to shorten up on your duration, protect you from rising rates, but we're going to take a little bit more credit risk because the economy is doing well, and corporate defaults are still at an all-time low. As long as we monitor the position, we can get a little bit more juice without taking on too much extra risk." do you make of these "defined maturity" corporate bond ETFs-some with longer duration-in the Guggenheim and iShares families? Are those products you take seriously as a way to manage interest-rate risk?

Hougan: Absolutely. I love those products.

The big thing investors will realize about fixed income-not necessarily over the next six months, but over the next two to three years-is that they'll have a sort of wake-up call on the total return aspect of a fixed-income ETF. If you buy a Treasury bond today, you actually don't really care what happens to it over the next five or 10 years until it matures.

It has really little bearing on your pattern of returns. You get your interest payments along the way that you know about, and you get all your money back at the end. And that's all that matters. Anything else that happens in the interim is noise. Investors have been embracing that noise for the last 30 years because interest rates have gone in one direction, and that total return has enhanced their returns.

But as interest rates start to turn, the original concept of a bond-where you put money down and you get all your money back and, in the interim, you get interest payments that you can count on-I think investors will find increasingly appealing. And these target-date maturity ETFs are a perfect match for that environment.

So as the total return of bonds starts to go the other way, I think some of that fixed-income money goes into those products. That's why we see iShares coming to the market with such aggressive pricing-10 basis points-they're really trying to capture this market because it's the right product at the right time.'s talk about emerging markets. They've definitely taken it on the chin. There's some concern that the bloom is off the rose and the great run is over. But there are others who say the recent sell-off in the emerging markets has set up the most prospective opportunity in the investment markets since the great crash of '08 and '09. What's your sense about it all?

Hougan: It's been a disaster. There's no way around that. The iShares Core MSCI Emerging Markets ETF (NYSEArca:IEMG) was one of my five ETFs to start the year. If there's ever a reminder that I should stick to index investing, there it is.

I read a really good piece on emerging markets by Tyler Mordy that's coming out in the September/October issue of the Journal of Indexes. His position was that the driving trend in emerging markets has shifted. For years and years, returns were driven by exports to developed economies, and therefore, the countries and companies that did well were export-oriented.

Hougan (cont'd.): But as global growth has slowed and developed economies have devalued their currencies and have gotten a bit of a competitive edge, those export-driven businesses are suffering. But what are not suffering are the consumer-directed economies within the emerging markets.

So if you look at something like the EGShares Emerging Markets Consumer ETF (NYSEArca:ECON), on a one-year basis, that fund is up about 15 percent. Emerging markets are flat, but ECON is up 15 percent. It hasn't kept pace with SPY, but it's doing a heck of a lot better than EEM.

I think Mordy is right that there may be a rotation into companies that benefit from the real and true growing wealth of the consumer class in emerging markets versus the historical investment paradigm that's focused on export-oriented companies. do you think about the historical opportunity that belonged to the emerging markets now moving to the frontier markets? I'm thinking of the iShares MSCI Frontier 100 ETF (NYSEArca:FM). It's probably the purest frontier markets ETF to-date. But are there too many caveats in those markets or even in the structure of that security?

Hougan: I'm a big fan of that security, and it has certainly performed well since its launch. Year-to-date, it's up about 10 percent-not that far off SPY. I think there's strength in frontier markets and I think there is opportunity there.

One thing to take into account, of course, is that the two biggest countries in the index are graduating. MSCI is promoting Qatar and the United Arab Emirates to emerging markets next year, and those two countries together are about 32 percent of the index. So the frontier markets ETF, FM, is going to get a lot more frontier market-y . It will have a lot more Nigeria and less UAE. And that means what's already a volatile market is going to become more volatile.

I think frontier has a place in every investor's portfolio-it's a small place, but the demographics are there and the economies are there and those markets are doing pretty well. It's bullish, but if it already was the "Wild West," once those two countries graduate, it's going to be the "Wild Wild West!"

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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