To outperform the flawed index, active managers must make fewer, more concentrated bets

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This week in “What the hell am I paying my fund manager for?” — emerging markets.

It has been years since investors were enthusiastic about emerging market equities, what with the commodities boom coming to an end, China slowing sharply and the Federal Reserve threatening to raise US interest rates. But that has changed in the past few months.

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The MSCI Emerging Markets index is up 32 per cent since a nadir in January, and US mutual funds and exchange traded funds that specialise in EM equity have enjoyed inflows throughout the summer, as investors chase this renewed performance.

Fund management firms’ marketing machines are cranking back into gear, and are once again arguing that investors will be better off picking active managers, rather than blindly following the index. So what is their argument, and what is the evidence?

Emerging markets indices, it is said, are different from those of developed world stock markets. Different, and worse. That MSCI index, for example, is tilted heavily towards just three countries; China, South Korea and Taiwan together make up more than 50 per cent of the index. That makes it a poor choice for investors seeking wide diversification.

Furthermore, within individual countries, stock markets can be dominated by a small number of already-large companies or, in cases such as China, by state-controlled companies that do not have the dynamism and growth potential that emerging economies are supposed to provide. A recent analysis by UBS found that large companies in emerging markets compare unfavourably with developed-world peers when it comes to return on equity, while mid-tier EM companies at least hold their own.

To win back market share from passive, active managers will need to make fewer, more concentrated bets

The implication is clear: it ought to be pretty simple for active fund managers to beat an EM benchmark, by overweighting smaller companies and by making straightforward decisions on whether to over- or underweight the big three countries.

So, how have they fared? First, the good news. EM managers do indeed perform better, relative to their benchmark indices, than fund managers playing in their domestic market, according to an assessment of US mutual funds and institutional accounts by S&P Dow Jones Indices.

However — and here is the bad news — they still underperform on average. According to S&P, 70 per cent of mutual funds underperformed the EM benchmark over the five years to December 2015, after hefty fees. Stockpicking successfully in emerging markets, it is said, requires deep local knowledge, favouring well-travelled and seasoned managers who do not come cheap. The expense ratio of the average emerging markets fund is 1.49 per cent, according to Morningstar, and although that is down from 1.61 per cent in 2012, it is not falling any faster than fees for mutual funds as a whole.

Lest one suspect that it is only the fees that make the difference, S&P found that even after adding back the funds’ expense ratio, 55 per cent of all emerging markets equity mutual funds in the US have underperformed the benchmark over the past five years.

Even institutional investors, with their privileged access and ability to negotiate lower fees, did not get the mooted benefits of active management; institutional accounts, as best S&P could tell, returned more than the EM benchmark precisely 50 per cent of the time. So much for those indices being easy to beat.

Perhaps the problem is cowardice.

It is now well established that the biggest factor in an EM fund managers’ success is not picking the right stocks, but rather picking stocks from the right countries. Marshall Stocker, global macro equity strategist and portfolio manager at Eaton Vance, in the latest issue of The Journal of Investing, finds the primacy of country choice — first identified in academic work in the 70s — has continued to hold true since the financial crisis. Yet in another paper earlier this year, Mr Stocker found that managers do not make bold bets on countries. The median mutual fund’s country weighting differs from the MSCI Emerging Markets index by less than 20 per cent. As he puts it in the title of the paper: “You’re all a bunch of closet indexers.”

It seems that investors have noticed. The recent inflows to emerging markets funds have not been distributed evenly; while exchange traded funds have swelled in size, money has continued to drain from actively-managed funds, according to UBS. To win back market share from passive, active managers will need to make fewer, more concentrated bets. In emerging markets, at least, they ought to be able to outperform flawed indices if they do.

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