The debate over active versus passive portfolio management has been raging for many years. In emerging markets, it is frequently argued that greater market inefficiencies can be exploited by the skilled manager. Though active managers have been losing assets to passively managed indexed products, an important place remains for managers who offer idiosyncratic strategies which can create alpha over the long-term. In fact, the proliferation of low-cost indexed products should benefit the active managers that are able to differentiate themselves and generate value.
Active managers with genuine alpha-generating skill (the ability to consistently outperform their benchmarks over time) could theoretically benefit from the current environment for several reasons.
First, passive products are a continuing menace to the marketing-driven closet-indexers that have largely dominated the industry. As these products are being replaced by passively-managed funds, competition for well crafted active products with skillful managers should decrease.
Second, it is increasingly evident that the flows into passive products that are almost always based on market -capitalization-weighted indexes are creating significant market distortions. By design, cap-weighted indexes are driven by absolute momentum, as money flows into the best performing stocks and out of the laggards. This tends to happen gradually in a bull-market like we have seen in recent years but could reverse more abruptly if we were to suffer a market drawdown caused by a recession or another reason. Skilled active managers might well be adept at exploiting these market distortions at that time.
A good reminder of the travails facing active managers is the annual report by SPIVA Scorecard of U.S. -managed mutual funds which is produced by S&P Dow Jones Indices, one of the largest providers of indices in the U.S. market. The latest report was published last week (SPIVA). The SPIVA Scorecard is considered the best measure of active performance because it compares a funds performance to its style category (ie., a U.S. small cap manager to the S&P500 Small Cap Index) and it adjusts for survivorship bias. This latter adjustment is particularly important for measuring long-term performance since for long periods (10-15 years) it is the case in many of the investment categories followed by SPIVA that close to half the funds have disappeared, presumably because of poor performance.
The chart below shows the results from the 2017 SPIVA scorecard. The data shows the percentage of funds that under-perform their indices. Though the 1-year numbers are relatively positive for active managers, 3-years and beyond show much worse results.the US market, where nearly 90% of managers underperform over 10 years. The U.S. numbers are very relevant because the S&P 500 index is by far the most followed benchmark in the U.S. market. In international markets, however, the MSCI benchmarks are the most commonly used by managers, so that certain distortions may exist in the SPIVA analysis.
This is particularly true in emerging markets, where the S&P/IFCI Composite Index used by SPIVA for comparative purposes is not at all commonly used as a benchmark by investors, the MSCI EM and FTSE-Russell EM being highly dominant. For an unexplained reason, the S&P/IFCI Composite Index performance numbers have been consistently higher than either the MSCI EM or FTSE, which results in the SPIVA Scorecard making EM managers look worse than they really are.
Comparing active returns to the more appropriate MSCI EM benchmark paints a slightly different story.
As shown below, EM funds do on average underperform the MSCI Index. However, on an asset weighted basis, funds actually manage to beat the index over the past five years and nearly track the benchmark on a 10-year basis. Given the high concentration of assets in the hands of relatively few managers, this is probably a fairer basis of analysis. It indicates that those firms with more assets may have two advantages. First, they may have superior resources to support the large cost-base necessary to hire highly-skilled managers and conduct serious fundamental analysis around the EM world. Second, they may also pass on their scale benefit to clients by lowering fees.
Several observations can be made on these results.
- The numbers show that there is alpha-generating capacity in the emerging market asset class, probably to a significantly higher degree than in the U.S. market. Before fees, most managers are generating significant levels of value-added. The larger managers show significant skill in exploiting what may be greater inefficiencies in emerging markets. However, most of this alpha-generation is kept in house to compensate portfolio managers and analyst and costly marketing organizations, so that the mutual fund investor does not reap the benefits. Despite pressure from ETFs, fees remain high, ranging from 1% to well over 2%. Of course, this is true only for mutual fund investors. Large institutional clients can negotiate much lower fees, and therefore capture a lot more of the alpha-generation.
- EM ETF’s are getting cheaper. Franklin Templeton’s recently launched EM country ETFs have net fees of 0.19%. S&P500 tracking ETFs are approaching zero cost, and surely fees will continue to fall for EM funds, as well.
- Moreover, the tax advantages of ETFs relative to mutual funds are still poorly understood by investors. Mutual funds are required to pay out all capital gains on an annual basis. Given the high average turnover of managed funds, capital gains can be significant. Not only, do ETFs normally have very low turnover but investors are not liable for capital gains taxes, and these can add up to significant amounts. This advantage for ETF’s translates into around an additional 1.0% annual return advantage for the ETF compared with the mutual fund. Again, this is an issue of little relevance to many institutional investors.
- In the future, successful mutual fund products will have to continue to lower expenses by reducing fees and turnover. They will also have to concentrate portfolios and make them markedly different from the indices.
- The investor should look for highly idiosyncratic funds (dissimilar from the benchmark) that follow a simple and understandable strategy that can be consistently followed over time to produce replicable results. These funds should also have a fee-structure, that aligns the interest of the manager and the investor, and that allows a significant portion of the alpha to be captured by the investor.
Fed Watch:
- US focus on trade gap misses the target (WSJ)
- The end of the liberal world order (Project Syndicate)
India Watch:
China Watch:
- Blackrock expects China’s market opening (Caixing)
- Yuan oil futures start trading in Shanghai (SCMP)
- China will tighten financial regulation (Caixing)
- Asset Management supervision rules tightened (Caixing)
- China cuts business taxes (Caixing)
- China’s oversupply of shared-bikes (The Atlantic)
- Facial recognition tools China’s surveillance state (The Atlantic)
- US aims to block China industrial policy (NYtimes)
- China term-limits and leadership quality (Project Syndicate)
- US tariffs aim at China’s industrial policy (FT)
- How to avoid a trade war (Project Syndicate)
- Trump will lose his trade war with China (SCMP)
China Technology Watch:
- China moves up the value chain (bloomberg)
- Qudian’s CEO joins $1 salary club (WIC)
- FCC wants to block China tech titans (Bloomberg)
- US FCC seeks to shut out Huawei (NYtimes)
- Huawei plans $20 billion in R&D in 2018 (FT)
- China wants its own chips in driverless cars (bloomberg)
Technology Watch
- Waymo driverless cars ambitious plans (The Atlantic)
- Electric vehicle trends (McKinsey)
EM Investor Watch
- The history of Singapore, the miracle of Asia (Youtube)
- Saudi Arabia will enter FTSE EM Index (FT
- Vietnam to promote private sector (FT)
- Trade wars in a tri-polar world (FT)
- Thailand’s economic transformation (Opengovasia)
Investor Watch: