In fact, based on our analysis, active mutual funds rated three stars or above by Morningstar have outperformed the median emerging markets equity ETF by over 100 basis points per year. The highly variable and diverse nature of the emerging markets equity asset class makes it well-suited to active management. By remaining benchmark-aware without being benchmark-guided, active managers are free to enhance value by maintaining flexibility in pursuit of attractive regions, industries and individual companies.
To better evaluate active managers of emerging markets equity requires an understanding of the factors that drive benchmark performance in various market conditions. This Insights report explains these benchmark dynamics, highlights the benefits of active management in emerging markets equity and presents some of the pitfalls of passive approaches.
The Popularity of ETFs in Emerging Markets Equity
Despite the benefits of active management, investments in emerging markets equity often flow by default to ETFs and other passive vehicles. Over the last five years, passive strategies have attracted almost 2.5 times more capital flows than active strategies in the U.S. In fact, $82bn of a total of $95bn in flows to emerging markets equity have been directed to passive emerging markets ETFs (Figure 1).
Figure 1. Five-year Cumulative Flows to U.S.-Listed Active and Passive EME Strategies
Source: Morningstar. As of June 30, 2019.
Emerging Markets Equity ETFs Lagging Their Benchmarks
In the broader capital markets, the rising popularity of ETFs sometimes may reflect an increased focus on fees. However, investors focused on efficiency and performance need to understand that ETFs for emerging markets equities are far less capable of delivering benchmark returns than ETFs tracking large capitalization U.S. equities. As shown in the charts below, the largest U.S. equity ETF (SPY) has managed to track the S&P 500 over the last 10 years, but the median EME passive ETF has underperformed the MSCI Emerging Markets benchmark. Further, two of the longest running and largest emerging markets ETFs have trailed their benchmarks by a substantial margin since their respective inception dates.
Figure 2. iShares MSCI Emerging Markets ETF Has Lagged its Benchmark Since Inception
Figure 3. Vanguard FTSE Emerging Markets ETF Has Lagged its Benchmark Since Inception
Over the last 10 years, iShares MSCI Emerging Markets ETF (EEM) and Vanguard FTSE Emerging Markets ETF (VWO) have finished in the 79th and 58th percentile respectively among all U.S.-listed emerging markets equity funds. (The variance in performance between the two is a function of iShares targeting the MSCI benchmark while Vanguard is based on the FTSE Russell, which excludes Korea.)
The Sources of Physical ETF Tracking Error
Physical ETFs attempt to track their target indexes by holding all, or a representative sample, of the underlying securities that make up the index. Generally higher tracking error in physical ETFs tied to the MSCI Emerging Markets index stems from a combination of factors, including the high number and relative illiquidity of the underlying constituent equities, as follows:
- Transaction pricing: Due to a lack of liquidity in certain securities, the stock price observed in the calculation of the index is not available to a tracking portfolio. Supply-demand dynamics can push the actual price at which a tracking portfolio can transact to buy or sell to a less favorable level.
- Optimized sampling: Physical emerging markets ETFs typically use optimized sampling techniques, whereby they hold a basket of securities designed to match the characteristics of the benchmark, but not exactly the same securities, in the same weightings. Optimized sampling is typically employed in situations where the index has fairly illiquid constituents, a large number of index members or where there exist legal and regulatory barriers to owning certain securities. The very nature of the sampling technique is imprecise, which can lead to higher tracking error. The same holds true for physical ETFs aiming to replicate the MSCI World index, which have lagged that index by 19 basis points on average, relative to synthetic, derivative-based counterparts.
- Depositary receipts: An additional factor that can affect the tracking efficiency of physical replication funds tracking the MSCI Emerging Markets index is that many of these funds trade American Depositary Receipts (ADRs) or Global Depositary Receipts (GDRs), instead of buying and selling the underlying local securities. Listed on large U.S. or European exchanges, ADRs and GDRs are designed to mirror the ownership of a company’s domestic stock listing. Deviations between these proxies and their local parents contributes to tracking error in ETFs.
- Fees: ETFs, like traditional mutual funds, charge management fees that detract from the products’ net asset value and, in many instances, prevent an ETF from matching the performance of the index it tracks. ETFs also incur shareholder transaction costs through brokerage commissions and bid-ask spreads—costs that take away from an investor’s actual return even if not captured in an ETF’s reported performance.
Many Active Strategies Outperform ETFs in EME
Given the above evidence of ETF’s difficulty replicating emerging markets equity benchmarks, we believe active management strategies should be compared not only to benchmarks, but also to passive strategies.
Taking a more detailed look at multiyear performance, mutual funds rated three stars or above by Morningstar have surpassed benchmark performance by roughly 50 basis points over the last 10 years on an annualized basis. At the same time, they have outperformed the median passive emerging markets equity ETF by over 100 basis points per year. The 100 basis point spread per year over 10 years may not appear significant, but the impact of annual compounding means an initial investment of $1 million would derive $181,000 of incremental return over the period using a three-star plus rated mutual fund.
Figure 4. Actively Managed Mutual Funds Have Outperformed ETFs by a Comfortable Margin
Compound annual return (percentage) for time period, as of June 30, 2019
|5 Year||7 Year||10 Year|
|Median Active EME 3+ Star Mutual Fund||2.62||4.74||6.29|
|Median EME Passive ETF||1.60||3.42||4.81|
|MSCI EM NR USD||2.49||4.15||5.81|
Benchmark Inefficiencies Provide Active Management Opportunities
Setting aside the tracking issues confronting emerging markets equity ETFs, we believe the MSCI emerging markets benchmark itself remains inefficient for the following reasons:
- Weighting by market capitalization implies a backward-looking bias toward stocks that have performed well in the past
- Holdings of state-owned enterprises, whose interests are not necessarily aligned with minority shareholders, can lead to unproductive capital allocation decisions
- Minimal exposure to small capitalization stocks hampers access to some of the fastest growing companies in emerging markets
- Lack of a financial viability requirement may detract from performance
- The MSCI benchmark is also limited to 1,193 constituents, when there are over 10,000 public companies in the broader emerging markets universe.
Some investors erroneously assume that all index providers apply some sort of quality criteria to the stocks under consideration for inclusion in order to ensure that only businesses of a certain caliber are eligible. In fact, only some indexes maintain requirements for admission. For a stock to be added to the S&P 500, for example, it first must demonstrate “financial viability” with positive GAAP earnings for the most recent year and the last four quarters. However, MSCI indices, including MSCI Emerging Markets, do not have a financial viability requirement, suggesting that both money earners and money losers can gain entry.
Active managers have the flexibility to build more efficient portfolios and to incorporate a preference for financial viability in their holdings.
The Benefits of Actively Targeting Profitable Companies
The Neuberger Berman Emerging Markets Equity team targets companies with strong business models because it believes that a company’s financial viability is an important contributor to the performance of its stock. To prove this point, we performed an analysis of the profitability and stock performance of MSCI Emerging Markets constituents over the last five years, as follows:
- We established the return on equity (ROE) as a proxy for profitability for all constituents of the MSCI Emerging Markets Index as of year-end of 2013.
- We then divided the index constituents into three profitability buckets:
- Year-end 2013 ROE >=15% captured 46% of index constituents with a weighted average ROE of 23%
- Year-end 2013 ROE <15% and > 0% captured 50% of index constituents with a weighted average ROE of 9%
- Year-end 2013 ROE <0% captured 3% of index constituents with a weighted average ROE of -15%
- We tracked their performance of the constituents stocks in each bucket for five years from 2014 through 2018.
Our analysis, as summarized in Figure 5 below, showed that the higher ROE bucket was responsible for the entirety of positive return in the index over the five year period 2014-2018. These results argue the active managers have a real opportunity to improve returns relative to the benchmark by focusing on higher ROE companies. The analysis demonstrates that highly profitable companies have yielded higher returns over time versus those that were barely profitable or not profitable. We also verified that this return disparity held true going back over time, by examining seven rolling five-year periods: from 2008 – 12 through 2014 – 18.
Figure 5. Lower ROE Companies Dragged Down Index Performance Over Five Years
Total return 2014-2018
|Index weighting as of December 2018||Total Return 2014–2018||Average Index Weighting over Five-Year Rolling Periods Ended 2013–2018||Average Five-Year Total Return, Rolling Periods Ended 2013–2018|
|MSCI Emerging Markets||100%||9%||100%||19%|
|0% < ROE < 15%||44%||-11%||49%||0%|
Source: FactSet, data as of December 31, 2018. Indices are unmanaged and are not available for direct investment. MSCI Emerging Markets Indexes are net total return indexes which reinvest dividends after the deduction of withholding taxes. Investing entails risks, including possible loss of principle. Past performance is no guarantee of future results.
By focusing on company profitability and taking a broader view of the emerging markets stock universe, active managers have real potential to positively differentiate their returns relative to passive strategies and their index benchmarks. Emerging markets equity is a particularly supportive asset class for active management given the above-mentioned divergence of returns among asset class constituents. The ETFs designed to track emerging markets equity indexes are challenged by illiquidity and sampling issues, while the indexes themselves can be inefficient due to the inclusion of less attractive companies and state run enterprises, for example. This all points to investors having to carefully consider their investment options in order to maximize the capital appreciation potential of this growth asset class.