Emerging markets are often held up as place where active can thrive, but this seems increasingly outdated.
Investing is full of maxims reflecting conventional wisdom. While useful on occasions, they should always be examined and updated to ensure they reflect the world today. One such rule is the idea that active management is better suited to emerging markets.
The argument is that in contrast to the efficient North American market, financial markets in the developing world are less efficient, meaning that active managers have a greater chance of adding value by uncovering undervalued stocks.
Yet this idea looks less convincing now. There are many ways to measure this but perhaps one of the easiest ways is by using the Morningstar Active/Passive Barometer. This semi-annual report evaluates active fund sectors against a composite of actual passive funds. The latest figures show that just over 30% of global emerging market funds have outperformed their passive peers over the past decade (with the latest results published by Morningstar in September 2020).
That’s not terrible. US equities, for example, have a success ratio for active funds in the single digits, suggesting that emerging markets are still a less efficient market overall. However, the rate that emerging markets funds outperform is on par with funds in the UK large-cap space (35%) and roughly half that of UK mid-caps (73%).
So, while they may be less efficient than the US, emerging markets are hardly unique in their relative inefficiency. You still have a two in three chance of your emerging market fund manager underperforming. This seems obvious when you consider why markets are regarded as efficient and hard to beat.
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Becoming more efficient
In America, in the post-war period, financial markets increasingly came to be dominated by sophisticated professionals, who much more systematically and rigorously researched the market. As a result, stock prices were much more likely to reflect “fair value”, in turn making the job of the managers harder.
As Peter Bernstein, an investment manager in the 1960s, notes in his book Capital Ideas: “We failed to recognise that the movement of increasing amounts of money into professional management, a process that was so rewarding to our own pocketbooks, would make it just that much more difficult for us to capture rewards for our clients’ pocketbooks. We could not beat the market because we were rapidly becoming the market.”
The same process is likely under way in emerging markets. In part, this increased amount of money is from international investors, including investors in popular emerging market funds. However, it is also driven by local trends, including wealthier local populations increasingly entrusting their savings to professional asset managers in emerging markets. Either way, emerging markets are becoming more efficient and harder to beat.
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Sticking close to the benchmark
On top of that, however, it seems that many active funds investing in emerging markets have portfolios that are somewhat similar to the benchmark index, the MSCI Emerging Market index.
As at the end of October 2020, the MSCI Emerging Market index’s largest holding was Alibaba(NYSE:BABA) (8.8%), followed by Tencent (SEHK:700) (6.7%), Taiwan Semiconductor (NYSE:TSM) (5.7%), Samsung Electronics (LSE:SMSN) (3.7%) and Meituan (SEHK:3690) (2%).
Many big emerging market funds have the same companies in their top holdings, albeit with different weightings.
For instance, top-performing Baillie Gifford Emerging Markets Leading Companies fund’s top five holdings are: Alibaba (9.5%), Taiwan Semiconductor (9.3%), Samsung (7.3%), Meituan (5.3%) and Tencent (5.1%). These are the same five stocks found in the MSCI index, but with slightly different weightings. Also in the fund’s top 10 holdings are JD.com (NASDAQ:JD), Naspers (LSE:NPSN) and Ping An (SEHK:2318) – also stocks found in the top 10 of the MSCI EM index.
Meanwhile, the popular JP Morgan Emerging Markets fund’s top five holdings are Taiwan Semiconductor (7.0%), Alibaba (6.9%), Tencent (4.4%) and Samsung (3.7%). In fifth place is Hong Kong insurance company AIA (SEHK:1299) (3.4%).
Likewise, BlackRock Emerging Market fund has the same top five holdings as the index, albeit with different weightings: Alibaba, Taiwan Semiconductor, Tencent, Samsung and Meituan. It is a similar story for most mainstream emerging market funds, be it Liontrust, Axa Framlington, Franklin Templeton and many others.
Of course, each fund weights these stocks in their own way, with some overweighting (holding more than the index) and some slightly underweight (holding less than the index).
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Meanwhile, each will have different weightings for smaller parts of their portfolio. But the point is that rather than being full of unknown companies, uncovered by deep research, most emerging market fund portfolios seem to be dominated by a handful of large-cap stocks that are not too different from that of the index as a whole.
Outperformance can still be achieved by fund managers weighting these stocks higher or lower than the index. Indeed, active funds in the US market have been able to do the same, overweighting some of the FAANGs to beat the S&P 500. Meanwhile, some funds will have the sort of small unknown stocks that help contribute to outperformance.
But the broad point is that, at least on the surface, if you are buying an active fund it won’t look too different than an emerging market tracker fund: a large chunk of your portfolio will be Chinese and Asian tech companies.
In addition, you have a one in three chance that the fund manager has tweaked their holdings by the right amount to provide a higher return than a basket of passive equivalents. Personally, when it comes to broad emerging market exposure, I’d rather stick with a cheap ETF tracking the index.
There is also the added bonus of emerging market trackers usually being substantially cheaper. The Vanguard FTSE Emerging Markets ETF USD Acc GBP (LSE:VFEG), for instance, charges just 0.22%, while many emerging market active funds charge closer to 1%.
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