For Financial Intermediaries, Institutional and Consultant use only. Not for redistribution under any circumstances. In focus Why active beats passive in emerging market equities June 2020 Investors have been debating the benefits of active versus passive management for many years. In certain asset classes, such as large cap US equities, the argument appears to have been won emphatically by passive managers. Passive now accounts for an estimated 55% of assets under management in large cap US equities, up from 35% just seven years ago. In emerging markets (EM), however, the debate continues. Kirsty McLaren Investment Director, Emerging Since the MSCI Emerging Markets Index was first launched at Market Equities the end of the 1980s, much has changed. In this paper we review the evolution of emerging equity markets, analyze why the cost of beta has decreased, and explain why we believe it still pays for investors to take an active approach in EM equities. We examine the evidence and build a more accurate picture of the costs and benefits of an active versus a passive approach to EM equities investing. We show that, although the all-in cost of EM index tracking has fallen dramatically, and can be below 20bps annually, the case for an active manager remains compelling. The longstanding, conventional wisdom is that although On the surface, this argument against active management seems active management does add value, fees offset any benefit to compelling, but we need to take into account market structure. the end investor. This is based on the premise that, however Most of the academic literature exploring active management inefficient a market, the average active investor by definition has focused on the US (and, to a much lesser extent other large cannot outperform the index (even before fees) since the index developed markets). However, the structure of the US equity performance is the average of all returns. market, its participants, regulatory framework and scrutiny are Figure 1: Relative performance of emerging versus developed equities 400 Series of EM currency crises 300 and debt defaults. TMT bubble US euities enoy sustained inflates DM equities period of outperformance 200 Following the FC, China enacts a massive economic stimulus 100 China oins the TO at the end of 2001 and integrates into the global economy 0 Dec 89 Dec 91 Dec 93 Dec 95 Dec 97 Dec 99 Dec 01 Dec 03 Dec 05 Dec 07 Dec 09 Dec 11 Dec 13 Dec 15 Dec 17 Dec 19 Past performance is not a guide to future performance and may not be repeated. Source: FactSet, Schroders, MSCI, December 31, 2019. MSCI Emerging Markets vs. MSCI World (USD, Gross). not replicated across EM. Most strikingly, the amount of change equities, with A shares included in the index at 20% of their free in the structure of EM indices means that the trading, and hence float. Should China relax its foreign ownership rules and A shares the cost of a passive indexed approach, is much higher than it be fully included at 100% of their free float, China’s weight in the is for developed markets. These differences present exploitable index would rise to over 50%. opportunities for active managers. EM benchmark indices have tended to lag the changes in the In EM, the proponents of active management argue that their opportunity set due to the process by which a country enters greater inefficiencies can be successfully exploited by well-resourced, an EM index. This typically involves consultations with investors skilled managers. The proponents of passive management counter and extended implementation periods. With the potential for that the benefits of any additional inefficiencies are at the very least further evolution in the future, active investors’ ability to anticipate offset by the costs of extracting them, including the search costs benchmark changes and invest outside the index remains valuable. involved in finding good active managers. Why the cost of beta in emerging markets has decreased How emerging equity markets have evolved Passive investing in EM equities began in earnest with the May Global investors began to invest in EM equities as a separate 1994 launch of the Vanguard Emerging Markets Stock Index allocation during the late 1980s and the asset class was Fund. The first dedicated EM equities ETF, the BLDRS Emerging popularized during the 1990s. Over the last 30 years, EM equities Markets 50 ADR Index Fund appeared in November 2002, and have provided positive long-term risk-adjusted excess returns was followed in April 2003 by the iShares MSCI Emerging Markets and enhanced portfolio diversification. However, as Figure 1 ETF. By the end of 2019, in the US alone, there were more than shows, a large degree of patience and a long investment horizon 50 global emerging market ETFs, with over $200 billion assets have been required as there have been long periods when EM under management (AUM), issued by more than 30 providers.1 equities have underperformed developed market (DM) equities. EM equities ETF costs vary, but in general benefit from economies In addition to the volatile performance ride, the opportunity of scale. The larger the ETF, the higher the average daily volume set for an EM equities investor has changed dramatically over (ADV) tends to be. Higher ADVs usually mean tighter bid/offer the last 30 years, as developing countries have opened their spreads as there are more secondary market transactions. markets to foreign investors and enhanced their operational and Many EM equities ETFs also reduce their ongoing total expense regulatory regimes. ratios (TERs) and their tracking errors through securities lending programs. The proceeds help to offset lower management Figure 2 shows how the MSCI Emerging Markets Index has fees, and some fraction of them may also be shared with the changed over the last 30 years. The biggest change is China, ETF itself. Costs have fallen over time as ETF providers have which has gone from zero to 36%, while Latin America’s weight pursued market share and their AUM have increased. A survey has shrunk by over 20%. of the US-listed EM equities ETFs shows an average annual TER of 0.5%, but with a wide range from 0.11% to 0.95%. The biggest change over the coming years is likely to come from the increased inclusion of China’s mainland-listed equities (A The benefits to scale are reflected in the market concentration of shares). By the end of 2019, China accounted for around a third EM ETFs. As Figure 3 shows, together the three largest EM ETFs of the MSCI Emerging Markets Index, predominantly offshore account for nearly 90% of the sector’s AUM. Figure 2: The MSCI Emerging Markets Index over Figure 3: EM Equities ETF concentration the last 30 years 2019 7 Other 4 13% 2009 Russia 4% 1999 16% 39% South 1989 Africa China 5% 34% Mexico 2% India 9% 34 Malaysia 2% Brazil Taiwan % Vanguard FTSE iShares Core MSCI 12% Emerging Marets ETF Emerging Marets ETF Korea iShares MSCI Schwab Emerging Other 12% Emerging Marets ETF Marets Equity ETF Source: MSCI, FactSet, December 31, 2019. MSCI Emerging Markets Index Weights Source: BofA ML, November 8 2019. Shown for illustration only. Does not reflect any 1989-2019. Indexes are unmanaged proxies for respective asset classes, and investors recommendation to buy or sell any security. cannot invest directly in any Index. 2 1Excludes EM small cap ETFs and single EM Country ETFs. The iShares Core MSCI Emerging Markets ETF (‘IEMG’), which The first consideration is whether there are systematic reasons launched in October 2012 and has grown to be the second behind the wide dispersion in returns. If this is the case, then rather largest ETF in the space with $62 billion AUM as of December than observing an alpha opportunity for active management, 2019, is a very low cost passive option. It tracks the broader MSCI these may be factor betas that can be captured by simple Emerging Markets IMI, which captures large, mid and small cap quantitative strategies. representation across 26 EM countries2. Like most EM equities ETFs it mimics index performance by physically sampling the Figures 6 and 7 show the performance of the two most common constituents. IEMG has kept its TER consistently below 20bps factor investing strategies in EM, value and size, using the since launch and for the last three years it has been just 14bps. Its corresponding MSCI Factor indices as proxies. Over a 30-year tracking error has also been consistently low. In contrast, its older period, value has outperformed by 4.4% annualized in US dollars, sister ETF, the iShares MSCI Emerging Markets ETF (‘EEM’), which while low size has outperformed by just 0.5% annualized in launched in 2003, is more expensive, with a TER of 70bps at the US dollars. However, the relative performance has not been end of September 2019. Although the EEM tracks the standard consistent. In each case, there have been long periods when the MSCI Emerging Markets Index, due to its high cost, assets have specific risk factor underperformed the broad EM index. It’s also flowed to the much cheaper IEMG. important to note that each of these strategies encompasses much higher annualized turnover (34.3% and 37.7%) than simply The old arguments against ETFs, particularly in EM equities, holding the broad EM index (9.4%), and this turnover would were that they are not that cheap, and that they don’t really track; substantially erode the factor returns achieved by investors, in so why not pay a bit more for active and the potential of some the case of the low size factor index to close to zero.