An Update on Active vs. Passive Investing in Emerging Markets

The  most under-rated aspect of investing is simplicity. Investors feel obliged to pursue complex methods to predict the future of the economy, the markets and corporate earnings and they then develop elaborate trading systems to leverage “superior” insights. This is often driven by clients who demand large teams of highly paid experts involved in complex strategies in order to justify paying management fees. If a process is too simple and transparent, the client may conclude that the manager is dispensable .

This dilemma is heightened  by the growing preponderance of passive indexing and “smart-beta” strategies, which offer market performance (“beta”) or the promise of factor-driven market outperformance (“alpha”) at ever-declining prices. These computer-driven quantitative strategies are the image of simplicity and transparency and can be manufactured cheaply.

These “passive “products increase the pressure on actively managed funds in two ways; first, they compress fees; second, they push managers to add skill and complexity which increases costs. This bad combination of lower fees and higher costs can only lead to a concentration of assets in those few active managers who can offer highly differentiated products.

These trends can be seen in the Year-end 2018 SPIVA Scorecard (Link, Link), which compares returns for U.S. mutual funds with their respective benchmarks. Here are some highlights from the report which concern emerging markets funds:

  • The number of available funds is declining, from 233 in 2015 to 210 a year-end 2018.
  • Larger funds perform better than smaller ones. This is seen in the higher returns on an asset-weighted basis than on an equal-weighted-by-fund basis. This advantage of larger funds over smaller funds is persistent over all time-periods and can be attributed to lower fees and higher skill.
  • 2018 was a difficult year for active managers, with 78% of managers underperforming their indices. The data for the past 15 years is shown below. Beyond, a one year time-frame, around 90% of managers underperform their indices.

Rolling three-year returns have also deteriorated, as shown in the following graph. This deterioration is also seen for global and  international funds.

     

  • Finally, SPIVA identifies low persistency in results for EM managers. While 41% of EM funds outperformed their indices for the 2012-2015 3-year period, only 7.5% of these funds continued to outperform the next year  (2016), 4.5% outperformed over the next two years (2016-2017) and zero outperformed for the next three years (2016-2018).

  Conclusion

The sobering data from the SPIVA scorecard highlights the challenges of active managers. To be successful, increasingly, active managers will need to focus on market niches where they can deploy unique skills and expertise, and/or pursue strategies that provide returns that are uncorrelated  to mainstream emerging market products. Some areas where active management may continue to be highly successful in “harvesting alpha” are the following:

  • Deep value contrarian investing. This strategy is highly out-of-favor because of a long period of underperformance of the value factor. Consequently, though it requires skillful fundamental research, it is under-researched because most managers have abandoned this discipline. This is the case at a time when opportunities are plentiful in the Indian and Brazilian markets, and particularly in the China A-share market.
  • Hedge Fund structures: Pure Alpha, shorting and trend following (CTA) strategies can provide returns uncorrelated to EM equities and valuable diversification.
  • Long-only, mainstream EM investors with low cost structures, long-term horizons and the ability to pursue strategies with high “tracking error” (the degree of  portfolio return uncorrelation with the benchmark). The problem is finding clients with long-term horizons and tolerance for “tracking error”.  The vast majority of both investors and clients prefer strategies that “hug” the benchmark, which makes alpha creation a remote possibility.

Trade Wars

  • Xi needs a trade deal (FT)
  • The reemergence of a two-bloc world (FT)
  • The deepening U.S. China crisis (Carnegie)
  • European Commission report on China relations (EC)
  • Should the U.S. run a trade surplus (Carnegie, Michael Pettis)
  • Why the U.S. debt must continue to rise (Carnegie, Pettis)
  • Turkey and India denied preferential U.S. trading status (FT)

India Watch  

  • India’s internet users are addicted to these apps from China (WSJ)
  • How India conquered youtube (FT)
  • Modi’s track record on the economy (The economist)
  • Increasing Indian demand for copper (Gorozen)
  • India’s growing share of oil imports (blog)
  • India turns its back on Silicon Valey (Venture beat)
  • India is right to resist cancerous U.S. tech monopolies (venture beat)
  • 5 more years of Modi? (Lowy)

China Watch:

  • Quality will drive China A- share returns (FT)
  • Lessons from Li Keqiang’s report to Congress (SCMP)
  • China breaks world box office record (SCMP)
  • Why China supports North Korea (Lowy)
  • China’s PM frets about the economy (The Economist)
  • China has no choice (Alhambra)
  • China’s economy is bottoming (SCMP)

China Technology  

Brazil Watch

EM Investor Watch

  • AMLO’s first 100 days (Wilson Center)
  • South Africa’s electricity sector woes (FT)
  • OECD Report on Global Corporate Debt (OECD)
  • Russia’s global ambitions in perspective (Carnegie)
  • South Africa stagnates as confidence wanes  (Bloomberg)
  • Postcard from Malaysia (Foreign Policy Journal)

Tech Watch

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