When investing in emerging markets, the odds of outperformance are stacked in favor of active managers. That’s because, unlike developed markets, emerging markets are a heterogeneous and inefficient asset class. Each individual market and region possesses unique characteristics, risks and opportunities, which can be best leveraged through active, on-the-ground management.
The underlying truth is that indices such as the MSCI Emerging Markets Index that are used by passive managers to invest in emerging markets are a poor representation of opportunities in these markets. Indices typically include only the largest stocks by market capitalization and exclude potentially faster growing small and medium cap stocks which can be accessed by active managers.
And the fact that roughly two thirds of emerging market stocks are excluded from the respective indices means that investors in passive index-based investments lose the opportunity to participate in the growth of the majority of emerging market equities.
On the other hand, active on-the-ground managers have the advantage of being “free to roam” in making their investment decisions, compared to passive managers who are restricted to investing in stocks in an index over which they have no control.
As well, “in certain niche markets, like emerging market and small company stocks … it is possible for an active manager to spot diamonds in the rough,” states a Wharton, University of Pennsylvania article.[i] Conversely, the performance of passive managers is dictated by the index.
To put this reality in perspective, one of the world’s largest index providers, S&P Dow Jones Indices, highlights the shortcomings of using a broad-based passive strategy to invest in emerging markets in its research paper, Emerging Markets: What’s in your Benchmark? It surmises: “Numerous factors, including country and regional combinations, can create vast differences in performance and return patterns. If you’re looking to boost returns through exposure to international markets, you may want to dig deeper and consider looking beyond traditional broad-based benchmarks to truly assess the value of an allocation to any of the world’s emerging economies.”[ii]
Unconstrained by sector bias
Another benefit of using active managers in emerging markets results from the fact that they are not constrained by the dominant sector bias in EM indices.