Emerging Market Portfolio Managers Against the ETFs

In the world of emerging markets it has generally been presumed that managers can justify higher fees for this asset class because they add more value. It is argued that emerging markets are less efficient because they are complex and under-followed by professional investors.  The relatively scarce qualified portfolio managers and analysts with the skills and experience to navigate the territory should command higher compensation.

While low-cost indexed products have increasingly disrupted the asset management industry, the arguments in favor of active management for the emerging markets asset class have persisted: (Bloomberg)

  • Market inefficiency – More complexity and less professional analysis gives a tangible advantage to managers capable of conducting in-depth research.
  • Benchmark composition – The index benchmark is full of unattractive countries, sectors and companies, that can be avoided by skilled managers. For example, heavy index weightings in poorly managed state enterprises and commodity producers can be avoided to outperform.

Moreover, EM managers may have the advantage that because of its relatively short history as an asset class less academic research has been conducted on performance factors. While in the U.S. academic research has identified the performance “anomalies” caused by tilting portfolios for value, size, quality and momentum, these factors are less well understood in EM and may be easier to exploit by managers.

The evidence partially supports the argument that professional managers of emerging markets funds add value, at least in comparison to managers of U.S. domestic and international funds.

For example, the table below shows the latest results of Morningstar’s Active/Passive Barometer (Morningstar ). Active EM managers, despite higher fees, are seen to perform better than their peers in U.S. and International asset classes, with particularly impressive results over the three and five year periods. On an asset weighted basis, which gives greater consideration to the larger funds, performance is even better. (Note, the data does not consider the greater tax efficiency and lower acquisition costs for ETFs).

The SPIVA Scorecard published annually by S&P Dow Jones Indices (S&P Indices)  shows much less impressive results for EM active managers. SPIVA claims to have a more rigorous approach, adjusting results for survivor bias and for style (e.g., growth vs. value). The SPIVA scorecard shows EM active funds under-performing indices over all periods, largely in a fashion similar to U.S. and International funds. As with Morningstar, SPIVA shows larger managers with better results.

Part of the discrepancy between SPIVA and Morningstar can be explained by the significantly stronger performance of the S&P/IFCI EM Index used by SPIVA compared to the ETF composite used by Morningstar. This causes confusion as both ETFs and active funds use various indices, and neither study adjusts for this. In any case, both reports agree on several points. First, active managers have not created value over the long term; second, larger asset managers create more value. The better performance of the larger funds may show that larger managers with greater analytical resources can add more value.

The Morningstar report also points out that the primary source of outperformance relative to peers for active managers is lower fees. This may also explain the better performance of the larger managers, assuming that they are passing on the benefits of scale economies to clients.

Certainly, the disruptive influence of EM indexed products will not go away and may worsen. It may be that EM active managers have benefited of late from the bear market of the past five years for several reasons. First, during down markets active managers benefit from holding cash. This becomes a source of performance drag during bull markets, and we may have already seen this effect during 2016. Furthermore, assuming positive performance for EM equities, indexed products are likely to be more formidable competitors in coming years, as they tend to outperform in bull markets.

Index products should be easier to beat in a five-year bear market for EM like the one we saw between 2011-2016. The benchmarks which most active managers as well as ETFs observe are market cap-weighted indices, which makes them classic trend-following instruments. When markets are rising and flows are abundant, the index keeps on increasing position sizes in winners and reducing positions in laggards. This led to huge positions in commodity stocks in 2006-2007 and to very high weightings in tech companies today. During bull markets, most active investors become nervous about valuations and the size of positions and retreat ahead of the indices. In a bear market the process reverses. The index pressures prices by selling its largest most overvalued positions. The collapse of commodity stocks during 2012-2014 created “easy alpha” for managers who were comfortable in stepping aside and waiting for valuations to return to normal levels.

The dilemma for EM managers is the same faced by managers in all asset classes disrupted by low-cost index funds. To justify their existence managers have to take much more risk than they are comfortable with. The vast majority of professionally managed funds can be considered “closet index funds” in the sense that they manage around the index. The difference between the portfolio and the index is known as the “active risk.”  Many actively managed funds will have around 15% of active risk, the remainder of the portfolio mimicking the benchmark. The problem is that an ETF like Vanguard’s VWO, charges a management fee of only 14 basis points (0.14%), while the active manager charges, on average, 1.5%  even though  85% of his assets only mimic the benchmark. Clearly identifying this issue, a firm like Blackrock, which manages both ETFs and active funds, is moving aggressively into highly concentrated actively managed portfolios with very high levels of active risk.

However, moving to highly concentrated portfolios with high active risk is something that very few managers can countenance. AS GMO’s Jeremy Grantham  never tires of saying, the primary behavior driver of asset managers is career risk ( GMO ). Unfortunately, the proliferation of low-cost alternatives is undermining the economics of the asset management industry and decreasing job security just at the time that managers need to embrace risk.

Us Fed watch:

India Watch:

  •  Indian market can triple over the next five years (Wisdom Tree)

China Watch:

China Technology Watch:

  • China outlines plans to be world leader in AI (Caixing Global)
  • Lenovo announces big push into AI (SCMP)

Technology Watch:

  • The return of basic sewing manufacuring to the U.S. ((FT)
  • Are robots the future of global finance (UBS)

EM Investor Watch:

  • Emerging Markets rally has “legs” (Van Eck)
  • Revisiting Allocation decisions in EM (GMO)
  • EM  breaks 10-year downtrend (The Reformed Broker)
  • The bullish case for EM (Mark Dow)
  • EM ETFs don’t all track the same index (ETF.com)

Investor Watch:

Notable Quotes: (Avondale)

 

Emerging markets have been weak for a long time: “since the financial crises, interest rates, currencies etcetera, we’ve had a prolonged period of about eight, nine years now where we have seen significant weakening of emerging market currencies…you actually see the volume component of these emerging markets continuing to be very, very low, while historically it was all volume-driven growth. I am convinced that that is coming back now.” —Unilever CEO Paul Polman (Packaged Goods)

China may be stabilizing: “China for example is actually much more stable than the last 12 to 18 months. I like what I’m seeing in China right now.” —Abbott CEO Miles White (Medical Device)

Chinese are still buying international assets: “we’re still seeing the trend of Chinese buying and international assets. ” —Goldman Sachs CFO Martin Chavez (Investment Bank)

“In the vast majority of asset classes, prospective returns are just about the lowest they have ever been,” Howard Marks (Oaktree Capital).

Notable Chart: