Market Efficiency in Emerging Markets

The emerging markets asset class is said to provide better opportunities for skilled investors because stocks are supposed to be priced more inefficiently than those in developed markets like the United States. However, important markets such as Brazil and Mexico have come to be dominated by highly sophisticated local and foreign institutional investors and are now probably nearly as efficiently priced as developed markets. Nevertheless, there are still significant pockets of inefficiency in markets where short-term traders and retail investors have a dominant presence and in large markets with many smaller stocks which are not on the radars of institutional investors. The Chinese A-share market and India are arguably the two markets which perhaps best display these characteristics and therefore offer the best opportunities for skilled investors to profit.

The SPIVA Scorecard, which is compiled bi-annually by S&P Dow Jones Indices, provides regular comparative data on the relative performance of actively and passively managed portfolios in different markets around the world. As previously discussed (active-vs-passive-in-emerging-markets), the data shows that emerging markets in general are somewhat less efficient than developed markets and provide some opportunities for skilled asset managers to outperform indices. This is particularly true for the larger asset managers, presumably because they have more and better resources to conduct fundamental research. SPIVA also provides detailed analysis on specific countries which provides an interesting view on which markets may provide the best opportunities for skilled managers to harvest alpha (i.e. outperformance relative to the market).

The table below shows the percentage of managers able to outperform indices over five and ten year periods in representative U.S. and emerging markets for the period ending at year-end 2017. The figures refer to managers in each country investing in their own domestic markets (i.e. Brazilian managers investing in Brazilian equities.) SPIVA uses its own indices for each market, and these are constructed to represent a market universe of easy accessible to the standard international investor. Domestic managers in each country may be measuring their performance in comparison to other benchmarks, which may be significantly different than the index used by SPIVA.

The first thing to note is that, by and large, markets are efficient.  U.S. large caps are exceptionally efficient, with only 10% of funds able to outperform over the long-term (10 years). Though smaller companies with less market capitalization are much less followed by Wall Street research firms and are deemed to be less efficiently priced, the evidence from SPIVA shows that only 4% of managers can beat the small-cap index over the long-term. The same is true in Europe where less than 15% of managers beat the index over the long-term.

Outside of the U.S., however, there appears to be large differences in the degree of market efficiency. Latin American markets, which are increasingly institutionalized and have a large participation of foreign institutional investors, appear highly efficient. SPIVA provides results net of fees, so in Latin America where fees can be exceptionally onerous, the numbers may be partially explained by high expenses. South Africa is another market highly dominated by institutional investors, which helps to explain why the market appears very efficient.

In addition to the high participation of institutional investors, the opportunity-set of investable stocks is another factor that determines market efficiency. Mexico, Chile and South Africa are very shallow markets dominated by very few stocks, so these are very well followed by investors. Brazil’s equity market has more depth, but still the very large and competent institutional investor base focuses mainly on a few dozen securities.

In the SPIVA data-base, India stands out as a particularly good environment for active investors. Well over half of managers outperform the index over five year periods, and almost half over ten years, despite relatively high fee structures. This high level of inefficiency points to a market where institutions still have a weak presence. This is particularly true in small and mid-caps, where foreigners are largely absent.

Though not yet covered by SPIVA, the other large and inefficient market is China. The China  A-share market (stocks listed in Shenzhen and Shanghai) is a very deep and growing market dominated by local traders and retail investors and with very little participation from institutional investors. Chinese A-shares were recently included for the first time  in both the FTSE and MSCI emerging markets indices followed by foreign investors and will become increasingly important in coming years.

In addition to having the highest -growth economies and the largest and most dynamic stock markets, China and India also provide the best opportunities for investors to outperform their competitors by engaging in thorough fundamental research.

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