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Market Outlook

Emerging markets: is active or passive investment more beneficial?

Passive investment offers many benefits over active investment, evidenced by its growing popularity. However, the same cases that can be made for the approach are not equal in every situation, as emerging markets throw some of the perceived wisdom about the approach into question.

American basketball legend Michael Jordan once summed up the reason for his success thus: “Some people want it to happen, some wish it would happen, others make it happen.”

He was of course talking about his career on the court, but the same recipe for success could recently be applied to emerging markets — where active, rather than passive investment, is king.

For emerging markets the hands-on, frequent trade approach of active investment of at least $100m has returned 4.8% a year after fees for the past three years, according to a recent Bloomberg study. That was almost double the 2.5% returned by their passive peers.

4.8%

Annual return after fees of an active investment of $100m in emerging markets for the past 3 years

 

It makes sense, when you think about it. Risks are higher and more amplified in emerging markets, where a passive approach that relies on gradual, long-term growth cannot respond to the volatile, uneven landscape.

 

The best and the worst

“An active approach in emerging markets is the one that works,” Alastair Reynolds, of Edinburgh investment management firm Martin Currie, told Bloomberg. “It’s not like a beauty competition in the index. In emerging markets, you’re getting exposed to the best and the worst.”

There’s also more scope for active managers to spot opportunities in emerging markets where some companies are not so well known. “Active managers have consistently struggled to outperform in more efficient markets such as US equities and large cap UK equities,” Patrick Connolly, IFA at Chase de Vere, tells whatinvestment.co.uk.

“Active managers have consistently struggled to outperform in more efficient markets such as US equities and large cap UK equities,” - Patrick Connolly, IFA at Chase de Vere

According to Connolly, the information about constituent companies in these markets is widely known and factored in to share values, and as such “managers are less able to spot opportunities others have missed”. The same cannot be said of emerging markets though.

“In these areas, companies are sometimes not as thoroughly researched, and managers may be able to take advantages of opportunities that have been missed by the market as a whole, Connolly explains.

 

The emerging market pattern

Last year no active fund underperformed the MSCI Emerging Markets index, and some outperformed spectacularly — First State Global Emerging Market Focus, for instance, returned 19.1%, Money Observer highlights. This contradicts the returns pattern in established markets, where passive funds have gained a foothold over active strategies in recent years - a trend underlined in August last year as assets in U.S. ETFs and index-based equity mutual funds topped those in active stock funds; the first time this had ever happened.

In the UK, Europe, the US and Japan, in times of stability the passive approach is tempting thanks not only to the obvious higher liquidity and lower fees, but to a belief that indices by definition offer a diverse investment.

Although that’s not necessarily the case. The MCSI world index, as Willis Towers Watson notes, comprises around 1,600 stocks but 40% of that index is made up of just 100 of those stocks. A high concentration that leaves passive investors more exposed than they might believe.

And the passive investors are certainly exposed right now. In developed markets, we’ve seen the UK’s blue-chip index slide alongside rising alarm from the increasing impact of Coronavirus since February. Last week, the FTSE 100 — alongside the Dow and the S&P500 — suffered its steepest one-day fall since 1987. As a result, active management and tactical, more reactive investments take on increasing appeal.

Recent advice from Mark Tepper, CEO of US Strategic Wealth Partners is to seize opportunities. “Warren Buffett says, ‘Be greedy when others are fearful,’ right? So, I think it’s the perfect opportunity,” he told CNBC.

 

Opportunities abound

Back in emerging markets, as stocks tumbled there’s still a flicker of light — in bonds. According to the Financial Times, and based on the Institute of International Finance (IFF), almost $42bn of EM assets have been “dumped”, as the paper puts it, by investors since the outbreak of the virus, but the overwhelming outflows have been from stocks.

In contrast, the bond index has held up well during the crisis and even in the maelstrom of recent days slipped only 2.1%, giving them what the publication  described as “an unaccustomed status as haven assets.”

“There have been so many bumps in the road in recent years for EMs that the urge to run to safety is so much greater this time around,” IIF chief economist Robin Brooks told the FT.

“There have been so many bumps in the road in recent years for EMs that the urge to run to safety is so much greater this time around” - IIF chief economist Robin Brooks

Adam Wolfe, EM economist at Absolute Strategy Research, believes emerging market bonds are “immune” to coronavirus. Ongoing efforts to control inflation and stabilise currencies by central banks and governments of emerging countries may have helped reduce their aversion to EM risk, the FT notes.

He’s far from alone in his views. BlackRock and Lazard Asset Management are among several other asset managers that have claimed growth will only be delayed, rather than derailed, by the virus, Bloomberg notes.

 

Will EM remain a safe bet?

It remains to be seen if EM bonds continue to offer safety — in the first month of the outbreak investors increased their exposure to them but throughout March that flow has reversed. Sovereign EM bonds in the benchmark JPMorgan EMBI Global Diversified index rose 1.7% in the six weeks to 4 March, but have fallen 5.2% in the 10 days since, according to FT analysis. But they’re not plummeting — yet.

5.2%

Sovereign EM bonds drop between 4th and 14th March

 

If encouraging news is to be found, it’s in the fact that the coronavirus contagion rate in China has slowed and in South Korea more people are now recovering daily than contracting the illness.

However, until this particular crisis passes, as with most investments the lowest risk is arguably to hedge one’s bets and combine active and passive approaches. “We often like to have a passive element within our client portfolios,” Neil Mumford, chartered financial planner at Milestone Wealth Management, tells whatinvestment.co.uk. “So, for instance, we’d balance the high-risk Scottish Mortgage Investment trust with, say, a Legal & General tracker fund,” Mumford explains.

Whether investments are active or passive, the pandemic has thrown even more uncertainty into the irregular science of investment — and that is likely to cloud everyone’s judgement for a little while to come.

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Past performance is not a reliable indicator of future results.

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