Active Management in Emerging Markets Equities

The long-term performance of U.S. actively managed mutual funds investing in emerging market equities has been problematic. This goes against the argument that emerging markets should provide more opportunities for skilled active investors because of greater market inefficiency. In fact, the ability of EM investors to provide results above their benchmarks has been in line with the experience of portfolio managers investing in the supposedly highly efficient U.S. markets for large capitalization stocks.

This disappointing reality is highlighted by a recent academic paper, “The performance of US-based emerging market mutual funds,” (Halil Kiymaz and Koray D. Simsek Rollins College – Crummer Graduate School of Business) (Link).

Kiymaz and Simsek looked at actively managed U.S. mutual funds classified as “Diversified Emerging Markets” during the January 2000 to May 2017 period, admittedly a relatively short period. They identified 222 specific mutual funds active over this period. The researchers did not adjust the results for style mandates. In other words, “growth” managers were not judged relative to the “growth” benchmark, and “value” investors were not compared to the “value” index.

A summary of their findings follows:

  • Median and mean annualized returns were 4.17 and 4.87%, respectively. This indicates better performance for the larger asset managers, presumably because of larger research budgets. These returns compare to 6.65% and 7.89% for the two major benchmarks, the MSCI Emerging Markets and the S&P/IFC Emerging markets, respectively.
  • Fee expenses, though declining during the period, reduced returns by 1.22%, with no difference between the smaller and larger managers.
  • Cash was a significant drag on performance, with larger managers holding more cash than smaller ones. The mean cash holding over the period was a very high 9%.
  • The mean turnover (a measure of the amount of change in a portfolio in a given year) of the fund universe was a high 65%, and very likely another drag on performance. Surprisingly, larger managers had considerably higher turnover than smaller ones, which may imply significant market impact on stock transactions.
  • The average fund was heavily over-weighted in larger capitalization, “blue chip” stocks. Moreover, a “quality” bias can be seen in the relatively low volatility of returns: standard deviation of returns were 17.43% compared to 22.2% for the benchmarks.
  • The average tenure of the portfolio managers responsible for the funds was only 4.5 years; once again, the larger funds having more experienced hands on the tiller.

Conclusions

The Kiymaz-Simsek paper point to various short-comings of active managers. First, of course, management fees and transactions costs reduce significantly the potential returns of the investor in the funds; second, managers do not seek to exploit well-documented small-cap and liquidity premiums, preferring the comfort of investing in the best “quality,” largest and most liquid companies; third, managers hold excess amounts of cash in what is most-likely a futile attempt to time the market.

With the abundance of very low-cost ETFs replicating most strategies now available to investors, fund managers need to provide a genuine alternative. In all likelihood, successful strategies will have to embrace some of the following characteristics:

  • High portfolio “active risk,” an industry metric which measures how different a portfolio is from its benchmark.
  • Greater focus on under-followed segments of the markets, which implies a disciplined contrarian mentality and focus on less liquid and unpopular stocks, and lower turnover and longer holding periods.
  • Boutique structures with experienced managers.

 

Trade Wars

 

  • The great decoupling (Oxford Energy)
  • KKR sees opportunity in China decoupling (KKR)
  • Banning technology will backfire on the U.S. (FT)
  • A G-2 world (project syndicate)
  • Ian Bremmer (Aviva)
  • Post-dollar networks (project syndicate)
  • Investing in the age of deglobalization  (FT)
  • Is American diplomacy with China dead? (AFSA)

India Watch

  • India’s digital transformation (McKinsey)

China Watch:

 

China Technology

Brazil Watch

 

EM Investor Watch

Tech Watch

  • Investing in Asian Innovation (Oppenheimer)
  • Trends in battery prices (BNEF)
  • Mary Meeker’s Internet Trends report (techcrunch)
  • Germany is losing the battery war (Spiegel)
  • Does automation in Michigan kill jobs in Mexico? (World Bank)

Investing

 

  • The age of wealth accumulation is over (FT)
  • An investment thesis for the next decade (Gavekal)
  • Dalio on Diversification (Dalio)
  • AI Creates Strategic Dilemmas (FT)
  • Fooled by randomness (macro-ops)
  • The imperative for international diversification (Swedroe)
  • The end of sell-side research (Epsilon)
  • Understanding why currencies move (macro-ops)
  • EM value as an anti-bubble (research affiliates)