Emerging Markets Investing: The Case for Passive Funds

The case for passive investing seems the strongest in developed markets, where information is widely accessible and securities are accurately priced

Monika Dutt 17 January, 2017 | 1:17PM
Facebook Twitter LinkedIn

In 2016, investors dipped their toe back into emerging-markets 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-markets currencies.

Over the past decade, emerging-markets funds have moved from being a mere satellite holding in many investors’ portfolios to a core allocation. Interestingly, and perhaps counterintuitively, investors are increasingly adopting a passive approach toward emerging-markets funds. Worldwide, assets in passively-managed emerging-markets equity funds have grown more than six times over the period, whereas assets have only doubled for their actively-managed peers.

Market Accessibility and Efficiency

At first glance, the case for passive investing seems the strongest in 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 oft-cited as among the least efficient, it may be easier to obtain an informational edge or identify mispriced securities.

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%, compared to 0.49% for emerging-markets equity ETFs. This means that a manager must generate annual gross returns that are at least 1.41 percentage points higher to offer the same returns as the average ETF in the group.

Beware Index Hugging Active Funds

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 its cheaper passively managed peers’. For example, the Schroder International Selection Emerging Markets fund, which charges 1.95% and keeps country weights within 5% of the MSCI Emerging Markets Index, has underperformed the much cheaper Vanguard Emerging Markets Stock Index fund offered at 0.27%, by nearly 1% since 2009 on an annualised basis. 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% since its inception in 2003, even though it charges 1.54%.

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

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.                                 

A version of this article appeared in Money Observer Magazine

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

Facebook Twitter LinkedIn

About Author

Monika Dutt  is a Passive Strategies Research Analyst for Morningstar Europe