After a tough 2015, emerging markets, particularly equities, posted strong performance the following year and, as we hit the tail end of 2017, are now in recovery.
While this asset class has gradually moved from the periphery towards the core of portfolios, investors are increasingly looking at passive ways to add to their exposure. Poor performance from some active managers, as well as volatility, have made low-cost ETFs more and more appealing.
But does a passive approach make sense all the time and across all of the diverse opportunities emerging markets offer? In this study we take a closer look at fund flows into passive and active funds in global emerging market equities and bonds to see where it makes sense to stay active.
What did we discover?
In 2015, investors pulled out of active funds in both local and hard currency emerging market debt, see graphs 1 to 3, (above and below). This move reached its peak in Q3 2015 just as the China crash was unravelling that summer. There was a switch towards passive funds from Q4 2015 to Q3 2016 which started to gain real momentum.
However, once emerging market fundamentals started to recover, investors began to revisit active funds, and this trend has taken off again in 2017. Inflows have slowed significantly into passive EMD funds while active fund flows are picking up.
Looking at performance of active managers for the year period to the end of September, it is evident why investors have rushed back. An impressive 82% of active managers have beaten their Citywire assigned benchmark in the Bonds – Emerging Markets Global Local Currency sector and 78% have outperformed their benchmark in the hard currency sector. In this case investors choosing an active approach have been rewarded with alpha.
However, the longer-term numbers paint a different picture. Over the last three years to the end of September, only 36% of local currency debt managers have outperformed and this proportion declines to a quarter in the hard currency sector.
This three-year period will have included the China crash and commodity price falls in 2015 which had a knock-on effect on performance numbers. Nevertheless, active managers have strongly outperformed the markets so far this year and the outlook has brightened.
A slightly different story emerges when we look at equity markets. Flows into passive funds topped active funds from Q1 2015 to Q2 2016. Active funds took over in Q3 2016 but fell back down in Q4 2016. Flows into passive funds have regained the lead in Q3 2017 and these are fast-becoming the favoured way to gain exposure to the emerging markets in the equity space.
In terms of performance, investors may have made the right call here over the past couple of years as active manager performance has been poor. Just a third of the active cohort have outperformed their benchmark over the year to the end of September.
Overall, it has made sense for investors to take a passive approach to emerging market equities but some opportunities may have been lost by ignoring the best active emerging market managers.
- The case for passive investing is stronger for developed markets where companies and debt issuers are well researched and information is widely available. However, emerging markets companies are often under-researched and markets are far less efficient. As a result, picking the right active manager can really add value.
- Passive investing in emerging markets can be beneficial to capture short-term rises. However, active investing is more rewarding in the longer term when a managers can react to sudden shocks in the markets and adjust portfolios accordingly.
- While there are managers who have proven their worth, often by moving beyond benchmarks, they can be hard to find. Nevertheless, diligence and research is likely to be rewarded, particularly in this varied sector.
This article originally appeared in the November edition of Citywire Selector magazine.