Can't capitalize on high volatility, return dispersion
Emerging markets are held up as the poster children for inefficiency and, it follows, as the perfect region for active managers to outperform benchmarks.
But despite heightened volatility, uncertainty and wide return dispersion — thanks in part to the so-called taper tantrum as a result of comments in May by then-chairman of the U.S. Federal Reserve, Ben Bernanke — the majority of money managers failed to outperform their benchmarks.
The J.P. Morgan Emerging Market Bond Global Diversified index lost 6.58% in 2013, compared with a gain of 18.53% in 2012. It was a similar story for equities, with the MSCI Emerging Markets index returning -2.25% in 2013, compared with 18.7% in 2012. It's better this year, as year to date through June 30, the J.P. Morgan Emerging Market Bond Global Diversified index returned 8.66%, while the MSCI Emerging Markets index has returned to positive performance, gaining 6.32%.
According to the inaugural S&P Indices Versus Active Funds Europe Scorecard — a measure of the performance of actively managed European equity funds, denominated in euros and British pounds, against their respective benchmark indexes — the negative returns for passive investments were evident also in actively managed strategies.
For euro-denominated emerging markets equities, 70.52% of strategies underperformed the S&P/IFCI composite benchmark for one year, 83.57% over three years and 87.65% over five years for periods ended Dec. 31. The S&P/IFCI composite is made up of the S&P Emerging Broad Market index, plus South Korea.
It was a similar, although slightly better, story for British pound-denominated strategies, with 60.8% underperforming for one year, 59.04% underperforming over three years and 62.5% failing to top the benchmark over five years.
A little better
Managers running U.S. dollar-denominated strategies fared a little better. The 2013 U.S. SPIVA report showed 57.48% of those emerging markets equity strategies underperformed the S&P/IFCI Composite index over one year, 60.87% underperformed over three years, and 80% failed to top the benchmark over five years.
“The volatility provides opportunity — that is where active managers are given opportunities to shine,” said Aye M. Soe, director, index research and design, at S&P Dow Jones Indices in New York. “Volatility creates return dispersion, and that in itself gives active managers opportunities. In 2013, despite the volatility, we saw active managers not able to translate that into real returns.”
But Ms. Soe said emerging markets benchmarks are tough to beat. “We have seen that across the globe. It is a pattern that you see consistently.”
Tim Edwards, director, index investment strategy at S&P Dow Jones Indices in London, said there is another issue. “Emerging markets, as we know, might not be as liquid, (might be) harder to access and involve more intermediaries (than developed markets,) and if you have an emerging markets product it tends to be at a higher fee rate. One possibility is that those are harder markets to trade frequently, and also the higher fees can affect returns,” Mr. Edwards said.
However, emerging markets are still “fertile ground for the kind of active decisions that managers can make. If you are right about your decisions, you stand to make a much more enhanced return. The fee may be higher, but the opportunity for alpha is so much greater that it is a challenge to fit it all together,” Mr. Edwards said.
A number of money management executives, both portfolio managers and analysts for emerging markets, were surprised that active managers had failed to outperform over the longer term. They were not so surprised at 2013's results.
But they did say that active managers trying to outperform in emerging markets faced some serious hurdles.
“The composition of the emerging markets equity index is problematic — roughly 45% of the index is China, South Korea and Taiwan,” said Peter Marber, Boston-based head of emerging markets at Loomis Sayles & Co. LP. “That high concentration means if managers don't get those countries right, it almost doesn't matter what they do anywhere else. For managers that build portfolios away from those heavy concentrations — with large tracking error — they may suffer some misalignment with index performance over short-term intervals.”
The index is also getting bigger, with the number of stocks increasing fourfold over the past five years, said Claire Peck, client portfolio manager for the emerging markets equity team at J.P. Morgan Asset Management (JPM) in London.
And emerging markets are becoming more efficient in another way, affecting some managers' ability to outperform, when it comes to the information at managers' fingertips.
“There was a real dearth of information when I started 20 years ago,” said Deborah Velez Medenica, senior vice president and portfolio manager at Fred Alger Management Inc. in New York. “Information was not readily available — the depth of transparency in the emerging markets was also at a very novel level. But there has been a maturation of the asset class, so that information arbitrage” is no longer there.
The money manager's emerging markets composite has outperformed the MSCI Emerging Markets index benchmark for one- and three-years. It was on par with the index for the three months to June 30, and for the first half of the year slightly underperformed.
J.P. Morgan Asset Management (JPM)'s flagship global emerging markets focused strategy outperformed the same benchmark over the three- and five-year periods through June 30, and since inception in May 1994. For the 12 months through June 30, it underperformed by two percentage points and was largely on par with the benchmark for the three months through June 30.
One area with which active managers might struggle relates to the way they make investment decisions.
“There is enormous return variation between emerging markets — at the country level — along with an enormous amount of volatility,” Mr. Marber said. “Some think this creates opportunity, which it does, but it also creates problems — particularly for managers that focus on company-specific opportunities with little regard for country factors They might be seduced by companies' local market share or cheap valuations, but don't always take into account the macro risks of the company's home country. They get so hyper-focused on the companies that it's often like looking at a bug on the bark of one tree, rather than stepping back and looking at (the whole) tree— let alone the forest.”
Ms. Peck agreed investors should drill deeper. “We see significant dispersion within regions,” she said, citing 2% returns for Asia overall in dollar terms, but with Taiwan up 9% and Indonesia down 23.5% in 2013.
Mr. Edwards said country selection has historically been more important for decisions over specific companies and sectors — the opposite of developed markets. But there is evidence this is changing, Mr. Marber said, with growing sector variation in China, for example, meaning the consumer bets “have outperformed many of the large market-cap-weighted, state-owned entities in the last couple of years.”
As for 2014, Mr. Edwards said, looking at the relationship between active managers' equal weighting to securities vs. the market-cap benchmarks “gives you a hint to how (managers) might be doing.”
It is pure speculation, Mr. Edwards said, but there are indications that 2014 might be an “averagely bad, if not slightly worse” year than 2013 for some active managers in emerging markets.
This article originally appeared in the September 1, 2014 print issue as, "Most emerging markets managers underperform".