Active Management is a Viable Option for Emerging Markets

We’ve all heard the passive beats active echoed over and over, citing the $1M bet made by Warren Buffet or the 90% of managers couldn’t beat the S&P 500 in a 10-year period. But is it really that clear cut?

Although generally true, there is evidence that suggets active has a better chance of outperforming passive in emerging markets due to unique cirumstances that only exist in that market. However, there is still contention on whether the odds are in active’s favour.

Does active outperform passive in Emerging Markets?

Data from Morningstar as at 31st Dec 2021 shows that US active managers had a 54.4% success rate against passive funds over 10 years, which is significantly better odds than the 1 out of 10 US large-cap active funds we often hear about.

This was not the case for European active managers, who had a 25.4% success rate over 10 years (Morningstar, 2021).

Tilley (2017) took 53 active managers from eVestment’s Global Emerging Markets Large Cap Equity universe and observed that the median active manager outperformed the MSCI EM Index over a 10-year period net of fees.

Kremnitzer (2012) found that actively managed mutual funds outperformed passive ETFs after-tax by 2.75% over a 3-year period, noting that the success of the active managers was largely from picking stocks with high price-book ratios.

SPIVA (2021) disagrees with active outperforming passive, reporting 94.74% of active managers underperforming the S&P/IFCI Composite over the last 20 years. But as Jvande pointed out, active and passive managers more commonly use the MSCI benchmarks. Not only that, but the S&P/IFCI Composite that they use as a benchmark consistently had higher returns than the MSCI Emerging Markets Index, making active managers look even worse. After replacing the S&P/IFCI Composite with the MSCI EM Index and adjusting for asset weight, active managers on average beat the index over 5 years and nearly tracked the index over 10 years.

Arguments for active management in Emerging Markets

• Passive ETFs lag their benchmarks as opposed to ETFs tracking developed markets due to factors such as high number and relative illiquidity of holdings, optimised sampling causing imprecise weightings, and use of depositary receipts (Saldanha and Skinner, 2020). This can be seen in VGE where it lags the benchmark by about 0.26% (after fees) since inception, whereas VAS or VGS do not differ from their benchmarks when taking fees into account. This ETF tracking error is why active ETFs should not only be compared to their benchmark but also passive ETFs.
• Emerging markets involve nations with varying economic and geopolitical differences, and so indiscriminately investing in all these nations through passive management may not be worth it for the diversification benefit you may get (Jenssen, 2017).
• The MSCI Emerging Markets Index excludes a lot of small and mid-cap companies as well as the frontier market, missing out on returns from fast growing companies that could have been capitalised through active management. For example, Baidu, the Google of China, was listed on the NASDAQ in 2005 and was added into the index in 2015. During 2005-2015, Baidu had a total return of 2,591% (Dorson, 2020).
• State-owned enterprises (SOEs) account for 22.4% of the MSCI Emerging Markets Index, where these companies’ interests may not align with the minority of shareholders, causing them to underperform. However, from December 2000 until November 2013, the gross returns of SOEs outperformed non-SOEs but has since underperformed (McLaren, 2020). On the other hand, Freiwald, Edwards and Perks (2021) observed non-SOEs outperforming SOEs by an average of 6.1% in total returns from 2010-2020.