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Industry voices

Emerging markets equities: Active vs. passive

Guido Giammattei
Guido Giammattei is a portfolio manager and head of research for RBC Global Asset Management’s London-based emerging markets team.

As the recent fallout from the Chinese stock market and the prospect of a U.S. interest rate rise continue to affect global markets, long-term investors might find it increasingly important to consider the case of active vs. passive management with regards to emerging markets investing. A number of conditions specific to emerging market present active management with an opportunity to take advantage of the recent increase in volatility.

1) (Truly) Active managers outperform in EM

Active managers in emerging market have significantly outperformed the MSCI Emerging Markets index over time, and typically have done so with less volatility than passive strategies available to investors.

The median emerging market active managers have generated, on average, a rolling five-year excess return of more than 200 basis points vs. the MSCI EMI in U.S. dollar terms over the 15 years ended Sept. 30, 2014 (Mercer Manager Performance Analytics, September 2014). Assuming an average management fee of 88 basis points, these returns are also maintained net of fees. Emerging market active managers also have achieved a higher Sharpe ratio and lower standard deviation compared to iShares emerging market ETF, one of the largest emerging market passive strategies (Mercer Manager Performance Analytics, December 2014). Furthermore, research shows a remarkable degree of consistency in the excess return generated by top emerging market portfolio managers.

We believe the key attributes necessary to outperform the market are a high active share and a strong and repeatable investment process. Active share measures the percentage of a portfolio that is different from its benchmark. Research shows portfolios with highest active share have enjoyed outperformance over time, whereas those with active share less than 60% are less likely to do so (Copley Fund Research, February 2015). In this context, we believe, it is important to have a bias toward active managers who are truly active — managers who are skilled at making diversified stock selection and confident in building portfolios that do not just hug a benchmark time after time.

2) Emerging markets equity is inefficient

Emerging market equity is still a relatively inefficient asset class where information can be priced in slowly and reliable data are far from universal. This provides opportunities for experienced and skilled managers to add value through stock picking. While passive investing might provide higher average returns in more efficient markets, this is not so for emerging markets.

The emerging market universe is very large and there are a high proportion of stocks with little or no analyst coverage at all. There are three times more stocks listed in the BRIC countries — Brazil, Russia, India and China — than the U.S., yet there are three times fewer analysts covering these stocks (UBS research, February 2015). In addition, and perhaps a reflection of the low level of coverage, the accuracy in forecasting emerging market earnings is lower than in developed markets (J.P. Morgan research, February 2015). This presents opportunities for fundamental analysis to exploit market inefficiencies.

3) Active investors can be selective

Most passive indexes are market-cap weighted so an investor is heavily exposed to the movement of a few large companies. Passive strategies commonly apply weights to particular markets and thus can focus on larger markets irrespective of their merits. Active portfolios can be selective and this is crucial in producing returns that beat the benchmark. The universe is big and there are many poorly run companies that have low corporate governance standards, particularly state-owned enterprises. SOEs make up approximately 30% of the MSCI EMI and as such, passive strategies inevitably invest in these often poorly performing companies as well. Choosing an active manager can give the investor the freedom to avoid these stocks.

Additionally investment prospects are highly differentiated between the various emerging markets. For instance, many emerging market countries are implementing a number of political and social reforms that we believe likely will improve their economies in the long term once these reforms pay off. Passive strategies do not make such judgments, country allocation is not an option and so an investor in passive strategies could miss significant opportunities.

4) The benchmark can be a poor reflection of the real opportunity set

The MSCI Emerging Markets index is a poor reflection of the opportunities offered by the emerging market universe. The number of stocks in the EMI represents only 8% of the total stocks available in the universe (JP Morgan research, February 2015). Moreover, emerging markets small-cap companies, frontier market companies and developed market companies that generate the majority of their revenue from emerging markets are excluded from passive strategies, whereas active managers can choose to allocate to these promising areas.

5) Implementing ESG factors can reduce risk

There are very few emerging market passive strategies that are benchmarked against environmental, social and governance indexes. Investors who believe in integrating ESG into their investment process might find it difficult to do so with passive managers.

ESG criteria can help identify long-term industry leaders and potentially reduce investment risk by providing insight into companies' operations. One study shows that emerging market companies with stronger ESG have delivered higher cash returns on average than their sector peers (GS Sustain, Growing Pains, May 2012). The same study shows compelling evidence that high-return companies that demonstrate stronger ESG management quality tend to maintain those returns for longer.

The lack of comprehensive research coverage in emerging market in general, and a dearth of ESG-related analysis in particular, make the bottom-up analysis of active managers in this area increasingly important. Because information is scarcer in emerging markets, active managers might use sustainability criteria as a way to make superior investment decisions.

The relative merits of active over passive investing continue to be subject of considerable debate across all asset classes with merits for both approaches. What is clear, however, is that active emerging market equity managers enjoy some distinct advantages compared to those using a purely passive approach. Active managers can navigate a universe with the size and diversity of emerging markets, one where many opportunities will never feature in the market index; and they also have the ability to factor in ESG analysis that is not available to the pure passive manager.

Guido Giammattei is a portfolio manager and head of research for RBC Global Asset Management's London-based emerging markets team.