In focus

Why active trumps passive in emerging market equities


Kirsty McLaren

Kirsty McLaren

Investment Director, Emerging Market Equities

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Investors have been debating the benefits of active versus passive management for many years. In certain asset classes, such as large cap US equities, the argument appears to have been won emphatically by passive managers. Passive now accounts for an estimated 55% of assets under management in large cap US equities, up from 35% just 7 years ago. In emerging markets (EM), however, the debate continues.

Since the MSCI Emerging Markets Index was first launched at the end of the 1980s, much has changed. In this paper we review the evolution of emerging equity markets, analyse why the cost of beta has decreased, and explain why we believe it still pays for investors to take an active approach in EM equities.

We examine the evidence and build a more accurate picture of the costs and benefits of an active versus a passive approach to EM equities investing. We show that, although the all-in cost of EM index tracking has fallen dramatically, and can be below 20bps annually, the case for an active manager remains compelling.

The longstanding, conventional wisdom is that although active management does add value, fees offset any benefit to the end investor. This is based on the premise that, however inefficient a market, the average active investor by definition cannot outperform the index (even before fees) since the index performance is the average of all returns.

On the surface, this argument against active management seems compelling, but we need to take into account market structure. Most of the academic literature exploring active management has focused on the US (and, to a much lesser extent other large developed markets). However, the structure of the US equity market, its participants, regulatory framework and scrutiny are not replicated across EM. Most strikingly, the amount of change in the structure of EM indices means that the trading, and hence the cost of a passive indexed approach, is much higher than it is for developed markets. These differences present exploitable opportunities for active managers.

In EM, the proponents of active management argue that their greater inefficiencies can be successfully exploited by well-resourced, skilled managers. The proponents of passive management counter that the benefits of any additional inefficiencies are at the very least offset by the costs of extracting them, including the search costs involved in finding good active managers.

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