Deutsche Asset Management has launched a new smart beta exchange traded fund that tracks emerging markets sovereign debt, while weighting its constituents according to the credit quality of the issuers. The db X-trackers iBoxx USD Emerging Sovereigns Quality Weighted UCITS ETF (XQUA) is launched on the London Stock Exchange and Deutsche Bourse.

Martin Weithofer, Managing Director and Head of Strategic Beta at Deutsche Asset Management

The new ETF tracks the Markit iBoxx USD Emerging Markets Sovereigns Quality Weighted Index which re-weights emerging market countries using a unique quality-weighted methodology based on fundamental factors. This is unlike traditional fixed income sovereign benchmarks, which typically weight constituents by market value of outstanding debt, which may increase the risk profile of the index by assigning the highest weight to the most indebted countries.

Martin Weithofer, Deutsche Asset Management’s Head of Strategic Beta. said in a statement: “For emerging markets… we found that the fundamental quality-weighted methodology can be useful in under-weighting countries prior to downgrades, which have often trailed fundamental underlying changes.”

Eligible bonds in the emerging markets quality-weighted index are selected in accordance with an adjustment methodology that grades sovereign issuers using a series of measures to gauge their fundamental strength. This involves analysing a country’s capital (the buffer for future debt expenses), character (willingness to pay), condition (macroeonomic situation) and capacity (ability to service interest and debt payments). Within these four categories sit a number of fundamental measures, such as GDP growth rate, foreign currency reserves, global competitiveness, inflation rate, history of default, and sovereign debt as a proportion of GDP.

The weighting of the country with the best score is doubled while that of the worst country is set to zero vs. the market value weighted benchmark. Countries in between are adjusted linearly based on their relative scores. By focusing on fundamentally strong debtors, a better risk/return profile can be achieved.

An investment in the quality-weighted ETF compared to a similar market-weighted investment may be able to offer better positioning ahead of events that significantly effect fund performance. For example, Venezuela’s sovereign debt market saw a significant downward correction in prices in the summer of 2014. The quality methodology would have had Venezuela 88% underweight before the correction. Also, the Brazil sovereign debt market’s progressive downward price correction since the middle of 2014 would have been preceded by a steady under-weighting of Brazil in the quality-weighted index.

Countries that are currently over-weighted in the emerging markets quality-weighted index – relative to a traditional non-weighted emerging markets sovereign index – include the Philippines and Turkey. Countries that are currently under-weighted in the emerging markets quality-weighted index include Brazil and Venezuela.

As of 31 March 2016, the annual yield of the emerging markets quality-weighted index is 4.5%, with duration of 6.9 years. The ETF contains an annual all-in fee of 0.50%.

The new fund complements the db X-trackers iBoxx Eurozone Sovereigns Quality Weighted UCITS ETF (XESQ), the firm’s first smart beta ETF to track a quality-weighted Eurozone sovereign bonds index, which launched in December 2015.