Dr. Marc-André Göricke, Senior Consultant at alpha portfolio advisors, provides empirical evidence on the benefits of an active approach in emerging markets and specific examples of active strategies that investors can use when investing in EM assets.
His thesis is that while investor sentiment in EM may be more volatile than in developed markets, the long-term opportunities do not change with the headlines. Market swings can provide opportunities for experienced active managers, who understand the value of individual companies or bonds, and can selectively take advantage of prices when they become detached from fundamentals.
Proponents of passive investing point to the efficient market hypothesis1 that suggests market prices reflect all available information. As a result, there would be no place for active management, as the excess return achieved by an investment manager is lower than the fee he receives. However, academic research has provided empirical evidence that not all capital markets are fully efficient all the time and that active management can create value in these cases. The drivers of this excess return, often referred to as alpha, are captured by the fundamental law of active management. 2
As illustrated in chart 1, an investor should look for three main success factors:
What does the picture look like for EM?
With the fundamental law in mind, alpha portfolio advisors, an independent consultant to institutional investors, conducted a study earlier this year on the alpha potential of equity strategies.3
The underlying data comprised about 3,000 institutional composites of equity strategies based on the eVestment database4. To avoid a survivorship bias, it includes inactive strategies as well. The data set spans the years 2006 to 2019 and reflects Global EM, US, and European equity strategies.
One of the main findings of the analysis confirms the fundamental law of active management: It pays off to be active in inefficient market segments where managers are able to apply their skills to many forecasting objects. As highlighted in chart 2, emerging markets and in particular small caps are one asset class where the prerequisites for success of active management are fulfilled. In Global EM, e.g., the study finds that the average alpha for small cap strategies is 2.89% p.a. higher than for large cap strategies, with a high statistical significance.
The study also elaborates on the drivers behind outperformance. It finds a higher outperformance for strategies that are smaller which intuitively makes sense, as strategies that outgrow their capacity become constrained. The firm size, in contrast however, has a positive influence on the outperformance. Apparently, larger firms with bigger analyst teams have better resources to turn every stone in their asset class to unearth inefficiencies and increase the number of forecasts they are able to make. Finally, active positioning has paid off according to this analysis, as an increase in the tracking error has led to a higher outperformance of the manager, all else remaining equal.
Turning now to emerging markets fixed income – what does the picture look like in this asset class? Analyzing strategies within their proprietary manager data base, alpha portfolio advisors finds that the median investment manager has provided a positive active return over the period 2015 to 2019. However, the active return was even higher in emerging markets corporate bonds and hard currency debt strategies compared to blend or local currency debt strategies, as shown in chart 3.
This observation again confirms the intuition of the fundamental law: Corporate bonds and hard currency debt are asset classes that offer more forecasting objects and potentially provide more inefficiencies than local currency debt markets. As case in point, the number of countries in the corporate benchmark is 3 times higher than in the local currency benchmark, while the number of issues is even nearly 8 times has high. Also, the non-Investment Grade quota within the corporate bond benchmark is double as high than in the local currency index, suggesting a broader opportunity set for managers willing to perform bottom-up research.
One illustration for an alpha opportunity in EM hard currency is the flat yield curve that is portrayed in chart 4. It appears as if investors are not compensated for taking on additional duration risk at the moment, in particular when moving into the 10+ years duration bucket that is a significant portion of the index. However, among other factors, different credit rating distributions need to be considered.
In such a situation, it looks promising for an active manager to select credits from the intermediate duration bucket, something that is not achievable with a naïve passive implementation.
While many capital markets are indeed efficient and therefore call for a cheap, passive investment strategy, there is a place for active managers whenever the asset class is inefficient. Emerging markets are such a place for active investors as confirmed by alpha portfolio advisors’ empirical evidence and their experience in practice.
Investors that plan to engage in emerging markets with an active managers should select the right partner who has the right resources on firm level and also the appropriate size on the strategy level. Then, they should allow enough degrees of freedom to take active risks. There are of course also other, qualitative characteristics like the personality of the portfolio manager or the background and motivation of the analyst team that should be evaluated in a thorough due diligence process. With the right preparation, investors can increase their chances of success in emerging markets versus a passive index solution.
1. Efficient capital markets: a review of theory and empirical work. Eugene Fama. The Journal of Finance 1970. 25 (2): 383–417. doi:10.1111/j.1540-6261.1970.tb00518.x
2. The fundamental law of active management. Richard C. Grinold. The Journal of Portfolio Management Spring 1989, 15 (3) 30-37; https://doi.org/10.3905/jpm.1989.409211
3. Marktnischen für aktives Management. Marc-Andre Göricke and Jochen Kleeberg. Absolut Report 03/2020.
4. The data-set comprises the large-cap and small-cap universe for US Equities, Global EM Equities and European Equities (latest data update from May 2020).