Five reasons to use an active fund manager in emerging markets
Five reasons to use an active fund manager in emerging markets
Many investors are attracted to emerging market companies for their high growth and investment returns potential.
For those investors comfortable with the higher risk that accompanies this, the next question is how to invest in these countries. This could be via a typically lower-cost, market-tracking product such as a passive fund. Or they could pay more and use an active fund manager, with the potential to receive a return above that of the market average?
In emerging markets in particular, we think that there is a strong case for using an active manager.
1. Emerging market active fund managers can capitalise on index evolution
The opportunity set – that is the countries and companies in the index - for an emerging market equities investor is constantly evolving.
It has changed dramatically over the last 30 years, as developing countries have opened their markets to foreign investors, and improved their operational and regulatory regimes.
The chart below shows how the MSCI Emerging Markets Index has changed over this period. The biggest change is China, which has gone from zero to 36% at the end of 2019 (at the time of writing China’s share of the index has risen to over 40%, due to index changes and year-to-date market performance), whilst Latin America’s weight has shrunk by over 20%. You can read more detail on the changes in the article we wrote back in 2018.
Kuwait will be added to the MSCI Emerging Markets Index in November this year, whilst MSCI is currently consulting with investors on whether to continue Argentina’s inclusion.
Why is this important?
With the potential for future evolution, active investors’ ability to anticipate benchmark changes and invest outside the index is valuable. It can enable active fund managers to identify and take advantage of attractive investment opportunities ahead of passive funds.
What this often means in practice is that active funds can enter a market in advance of its inclusion in the index. These events are well-flagged by index providers such as MSCI, and active funds, unlike index-following products, are usually free to invest at a time they view attractive, rather than from a specified date.
2. Retail investor dominance
Although not always the case, institutional investors typically have greater time and resources to dedicate to asset valuations, and trade on information and set prices. Conversely, retail investors do not usually have the same means to conduct company research, and in some cases asset valuation is not a part of their buying and selling decisions. A higher share of informed investors in a market makes that market more efficient and reduces the opportunities for active investors. We can use the market share of institutional investors as a rough proxy for the market share of informed investors.
In the chart above, we show the percentage participation of institutional investors in a range of global equity markets. The share of institutional investors, both international and domestic, is on average lower in emerging equity markets than it is in the US and other major developed markets, and in some instances, such as China, very much lower.
It’s not therefore simply the amount of change in emerging market indices that makes emerging markets a more favourable environment for active managers than the more stable developed markets. The higher share of retail participants in emerging stock markets should be positive for fund managers with robust investment processes based on fundamental research.
3. The performance of different countries and stocks varies greatly – this provides opportunities
An important point to make is that the description “emerging”, relates to the stock market as opposed to the country. Emerging market countries are in fact highly diverse and at very different stages of development. They include Qatar, where GDP per capita is higher than in the US, through to Pakistan where GDP per capita is around one fiftieth of that in the US.
Partly as a result of this diversity, the spread of returns from countries and stocks has been persistently wide. The chart below shows the dispersion of one year returns for the countries in the MSCI Emerging Markets Index, going back to 1991, highlighting the median average return. Although the range has reduced since the financial crisis in 2008, there is still a wide spread between the best and worst performing countries (the height of the blue bar).
This potentially creates opportunities for active managers to generate returns in excess of the market average. This can be achieved by holding a higher exposure of their fund than the index to countries and stocks which perform better than the market, and by maintaining a lower exposure to, or avoiding altogether, those which underperform.
Furthermore, many of these markets are under-researched in comparison to developed markets. This provides the opportunity for a fund manager and team of analysts to uncover attractive investment opportunities before these are reflected in market prices. Of course, as we mentioned at the outset, investment in emerging markets is higher risk and returns can be more volatile.
4. Better integration of environmental, social and governance issues
Environmental, social and governance, or ESG, concerns are more important today than ever before, and these are particularly significant in emerging markets.
Company disclosure in emerging markets is, in some cases, poor and regulation may be less stringent. Corporate governance standards vary widely. Meanwhile minority shareholders can be a lower priority, which often translates to weaker share price performance.
We think that fund managers are able to gain an edge on index tracking products, by integrating ESG considerations into their investment process. By meeting with companies, fund managers can better understand the issues that they face, and how they are managing them.
Some products which track an index often try to filter out companies which do not meet certain ESG standards. However, these methods are usually backward looking, dependent on the quality and consistency of data, and do not place any value on engagement with companies. Third party companies provide ESG ratings, but there is little consistency between different providers.
One factor behind poor governance standards is the prevalence of state-owned enterprises (SOEs). SOEs account for more than 20% of the companies in the MSCI Emerging Markets Index, compared to less than 1% in the MSCI World. These are companies which are publicly listed, but in which the state has a controlling share; the government can appoint management and dictate how they are run.
In SOEs, controlling shareholders interests are not always aligned with those of minority shareholders. An active manager can benefit by anticipating periods when interests are or are not aligned. Most index tracking products, by contrast, would hold exposure to these companies at all times.
5. The performance of active funds versus trackers in emerging markets is favourable
Data from Copley Fund Research shows that over the five-year period ending December 2019, around two-thirds of active managers outperformed the passive products that most investors can access, net of institutional management fees. This is based on a sample of 222 actively managed global emerging market equities funds with a combined $350 billion in assets under management.
However, it’s not always plain sailing right from the start. You need to hold a fund for more than a year, and preferably up to three years, before it starts to outperform reliably. (The exception to this was the global financial crisis when active managers underperformed, and took a long time to recover.) An investor needs to have conviction that a manager’s investment process can deliver above market average returns, and confidence that the manager is sticking to that process.
Indeed, the fund selection challenge needs to be reframed. Rather than trying to pick the top-performing fund, institutional investors should try to avoid the worst performing funds, which is potentially a much easier task.
Of course, retail investors pay higher fees, which reduces active funds’ net performance versus index following alternatives. However, the higher fees do not propel index trackers convincingly into the top half of performers. As an example, a US retail investor choosing an active emerging markets fund at random would have outperformed a market tracker alternative roughly half the time over the past five years.
Another point to be made is that although retail investors do not have direct access to managers to conduct due diligence, they do have indirect access if they go through an intermediary who undertakes manager research on their behalf.
For retail investors, despite the higher fees and with some due diligence, it can still make sense to choose an active manager in emerging markets. Particularly in an environment where any outperformance can be a significant portion of the overall return.
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