Lebanon's woes highlight pitfalls of passive EM portfolios

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      By Emerging Markets Debt TeamEaton Vance Management

      Boston - Last December, the EM debt team cautioned in our blog that Lebanon has racked up one of the world's largest debt burdens without the economic growth to finance it - in effect, a Ponzi scheme. Now the day of reckoning appears to be looming closer - Lebanese officials are debating whether to default on $1.2 billion of eurobonds maturing on March 9.

      For investors, one key lesson of the Lebanon episode is the risk inherent in a rules-based ETF whose portfolio passively mirrors a benchmark. All EM managers, whether active or passive, must deal with the volatility inherent in the sector, relative to developed market debt. Passive managers, however, are constrained in how they can seek to avoid or mitigate downside risk when there is perceived trouble for a country that is part of the index.

      Lebanon's bonds (the 6-3/8 coupon, due March 9, 2020) first took a hit in October as protesters took to the streets to demonstrate against decades of government corruption, low economic growth and high unemployment. Prices of Lebanese bonds have been highly volatile since then, with the ebb and flow of the news. As the prospect of a default seemed to loom larger since the start of the year, the bonds have lost more than one-third of their value, and now trade around 60 (see chart).

      Lebanon's bonds have been highly volatile


      Managers of rules-based, emerging-market ETFs, including the largest ones in the market, have had no choice but to hang on to the Lebanese bonds, along with their volatility and losses. Since the end of June, for example, Lebanese issues have comprised an average of 1.4% of the J.P. Morgan Emerging Market Bond Index - Global Diversified (EMBIG). Of course, investors can always sell their EM ETF holdings, but that entails what we see as a major drawback -- reducing or eliminating their EM debt exposure because of one portfolio position.

      We have long maintained that index-based investing is not optimal for emerging markets. Benchmark valuations may be unattractive, from an asset price perspective, at any given time. Nevertheless, they are, by definition, required holdings for benchmark-based ETFs. Index inclusion is based on minimum requirements for debt outstanding and liquidity, and may even reflect the biases of where the index provider seeks to do business - hardly a relevant factor for generating alpha in the portfolio.

      By contrast, the EM debt team focuses on country-level macroeconomic and political research across the globe, with stand-alone analysis of specific risk factors. We seek debt where pricing does not reflect the fundamental value that we see, and determine whether a country's risk premium is likely to increase or decrease.

      Bottom line: Lebanon's recent troubles have a key takeaway: Passive investing may have an increasing role in today's markets, but we do not believe it is the best approach for EM investors.