Investing in emerging markets: should you go passive, or stay active?

robot-and-human-reaching-for-globe

In 2016, investors dipped their soup ladles back into emerging market equity funds. The optimism in investor sentiment was sparked by a more positive global outlook on the Chinese economy and a stabilisation in commodity prices and emerging market currencies.

Over the past decade, emerging market funds have moved from being a mere satellite holding in many investors' portfolios to a core allocation. Interestingly, and perhaps counter-intuitively, investors are increasingly adopting a passive approach toward emerging market funds.

Worldwide, assets in passively managed emerging market equity funds have grown by more than six times over the period, whereas assets have only doubled for their actively managed peers.

How to invest using exchange traded funds

MISPRICING OPPORTUNITY

At first glance, the case for passive investing seems the strongest for developed markets, where information is widely accessible and securities are accurately priced.

In the US, this is supported by the fact that over its history, the high-profile S&P 500 index has proved a tough hurdle for many US large-cap managers to clear.

Meanwhile, in emerging markets, which are often cited as among the least efficient, it may be easier for stock-pickers to obtain an informational edge or identify mispriced securities.

The cheapest ways to track global stock markets

In theory, that story makes sense; but in practice it doesn't always hold. If there is scope for an experienced active manager to outperform a standard large-cap benchmark, then it is also true that an 'unskilled' or 'unlucky' manager can impair investor returns more than an index fund.

Additionally, active funds are usually much more expensive than their passive counterparts. The greater the fee differential between active and passive funds, the higher the cost hurdle active managers must clear.

In Europe, the average annual fee for emerging-markets equity funds is 1.9 per cent, compared to 0.49 per cent for emerging market equity exchange traded funds (ETFs).

This means that a manager must generate annual gross returns that are at least 1.41 percentage points higher just to offer the same returns as the average ETF in the group.

FUNDS MUST BE 'TRULY ACTIVE'

Equally important is whether the active fund is truly 'active'. If the manager doesn't deviate much from the benchmark, then the fund's long-term performance will likely trail behind that of its cheaper passively managed peers.

For example, the Schroder International Selection Emerging Markets A Acc fund, which charges 1.95 per cent and keeps country weights within 5 per cent of the MSCI Emerging Markets index, has underperformed the much cheaper Vanguard Emerging Markets Stock Index fund, offered at 0.4 per cent, by nearly 1 per cent since 2009 on an annualised basis (see chart below, click to enlarge).

schroder-emerging-markets-versus-vanguard-emerging-markets

It's no surprise that accepting index-like performance without having index-like costs is not a winning hand.

For managers to compete with passive funds, they must deviate away from benchmarks by taking active bets based on their best ideas, and hope the pendulum swings in their direction.

A good example of a fund that adopts this approach is the Comgest Growth Emerging Markets fund, which has outperformed the MSCI Emerging Markets index by 0.79 per cent since its inception in 2003, even though it charges 1.54 per cent.

Active managers also have the flexibility to invest in developed market stocks with high exposure to emerging markets, which are not eligible for inclusion in emerging market indices. More than 2 per cent of Comgest's portfolio is invested in UK stocks.

congest-growth-emerging-markets-versus-index

To conclude, investors considering emerging markets equity exposure may be tempted to disregard passive funds on the premise that emerging markets represent a less efficient area of the investment world where active managers can add value.

While there are managers who have proven their worth, often by staying away from benchmarks, they are difficult to find. With that in mind, investors may be better served by choosing a low-cost fund tracking a broad and well-representative emerging markets equity benchmark.


Subscribe to Money Observer magazine

 

Comments

Post new comment

The content of this field is kept private and will not be shown publicly.
By submitting this form, you accept the Mollom privacy policy.