The benefits of staying active

Good news from developing economies: after a very difficult 2022, stocks listed on emerging markets have performed much more strongly in 2023. China’s decision to reverse its “zero Covid” policy, which led to so much disruption, has been one trigger for recovery. The fact that emerging markets are such a long way from the problems in US and European banking has also helped.

However, while investors appear to be taking a renewed interest, with strong flows of cash into funds offering exposure to emerging markets, something odd is going on. Around three-quarters of these inflows have gone into passive funds that simply track emerging market indices up and down. Active funds, where a manager is paid to select markets and stocks they expect to outperform, remain out of favour.

You might think that isn’t peculiar at all, given that passive funds have dominated the whole investment market in recent years. But traditionally, the passive approach has been thought inappropriate for emerging markets.

There are good reasons for that. Passive investment can make sense in mature stock markets where individual shares are covered by legions of analysts and all investors have access to plenty of research and information. That makes it harder for an active manager to outperform – with so much data available, such markets operate efficiently, and pricing anomalies are hard to find.

Emerging markets, by contrast, are less efficient. Information is in short supply and often patchy. Active managers therefore have more opportunities to add value. The best managers are adept at spotting diamonds in the rough.

Also, emerging markets are, by their nature, more volatile than their developed counterparts. In a passive fund, investors are completely exposed to that volatility – the fund tracks the market up and down. Active managers, on the other hand, can take steps to protect investors.

That’s the theory. Why, then, are investors flooding into passive funds in emerging markets?

The answer is probably that they’re doing so for the same reason as they often prefer trackers elsewhere. Investors know active managers can underperform the market as well as outperform; they therefore worry about their own ability to pick funds that do the latter. In which case, the passive approach feels like a safer option, particularly since fees are typically lower.

This approach is understandable, but it’s also potentially disappointing: the data suggests the arguments for an active approach to emerging markets investment do play out in practice. One recent study found that actively managed emerging market funds had outperformed their passive rivals in more than 70% of cases over the previous decade.

Moreover, if you go passive in emerging markets, you’re automatically ruling out getting your exposure via an investment company, where every single fund is actively managed. That’s doubly unfortunate – FE Analytics data reveals that the average emerging markets investment company has delivered a full 7 percentage points more performance than its open-ended equivalent over the past decade.

In fact, the outperformance of investment companies should not come as a surprise, since these funds have natural advantages that come to the fore in emerging markets. Their structure means managers don’t have to worry about liquidity, enabling them to operate with greater agility in potentially tricky markets. And investment companies can take on gearing to boost returns during periods when markets are performing strongly.

The performance data therefore provides important food for thought. There are lots of good reasons to consider emerging markets investment for superior long-term performance – the demographic and economic potential of these economies is stellar. But think twice before following the crowd into a passive fund; if an actively managed investment company makes sense anywhere, this is it.