Should investors get active on emerging markets?

Looking at the data, one would be forgiven for saying “not always, not everywhere”. This is where Morningstar’s European Active/Passive Barometer, a semi-annual report that measures the performance of European-domiciled active and passive funds in their respective Morningstar categories, can help. The report includes almost 26,000 funds representing around half of the total European fund market, and the latest edition has data up to the end of June 2024.

Emerging market stocks had a positive first half of 2024, even outperforming global developed market indices in the second quarter. Easing concerns about China and softening expectations of a US interest rate cut helped. The Morningstar study tells us that “passive funds have incorporated the full advantage and made it more difficult for active managers to outperform.”

This is the opposite of what we saw in 2023. As China had become synonymous with underperformance, global emerging market equity category managers found an easy way to beat passive alternatives by taking a cautious approach to the Asian country.

The one-year success rate for active managers in this category was 40.2% in June, down from 46.3% in December 2023, while the 10-year success rate was broadly flat at 28 %. Success rates are defined as when active funds outperform their passive counterparts over a period of time.

The table above shows the average success rate for the broad categories of emerging stocks, which show very different results, making it more difficult to reach a firm conclusion.

For Indian stocks, active managers have achieved high success over the past 10 years (53.4%). Active Chinese equity managers have done even better over the past 5 years (62.6%). That said, these are the only two cases where active managers have a success rate above 50%.

The flight of active investors from EM

The pessimism hovering over emerging equity markets, particularly in China, is reflected in the outflows experienced by exposed funds. In the past year, investors have redeemed €11.4 billion from European-domiciled actively managed emerging markets global equity funds (as of 31 July 2024).

However, in the same period, passive funds in the same category took in net inflows of €4 billion, marking an organic growth of 2.55%.

The heart of the active/passive debate: costs

“Conventional wisdom says that active managers should have higher success rates in less efficient markets such as emerging markets. But in fact, the data tells a different story,” says Monika Calay, director of passive strategies research at Morningstar.

Over both short and long periods, the success rates of active managers in emerging markets have been less than 50%, meaning that passive funds are outperforming.

The main reason is cost, Calay continues. “In fact, active managers are expensive in this category, five to six times more expensive than their passive counterparts.” For example, passive emerging market equity funds tend to charge between 18 and 60 basis points (0.18% to 0.60%), while the average level of fees for active funds is 1.8 %.

Inefficiency of passive funds

Looking at regional indices such as the FTSE Emerging Index or MSCI Emerging Markets, which are the most widely used benchmarks, the biggest concerns are the concentration in a small number of countries. To give an example, China, Taiwan and India account for approximately 60% of the total portfolio weight in these indices. Active managers also have large single-country allocations, but in theory that’s because they’re hopefully doing fundamental research that supports those weights.

“We are also concerned about political risks. An illustration of this was March 2022 when Russia was essentially deleted from these benchmarks and as a result asset managers had to write down those positions to zero,” adds Calay. “There are therefore real concerns in choosing passive funds, but there are some aspects of these strategies that remain attractive.”

In a weak market, active funds make the difference

When we look at the data, only about 24% of active managers in the emerging market equity category survive and outperform their passive peers at 15 years. Thus, identifying a qualified fund manager in this asset class is not as easy as it might seem. And the number of active funds that have closed or merged in the last 10 years is about 40% in these categories.

“It’s a common misconception that emerging market inefficiencies make it easier to identify qualified active managers, and investors looking to access this asset class still need to do their due diligence,” explains the Morningstar analyst.

But recent performance has been more positive for active managers in this space.

“In 2023 we saw the increase in success rates in the emerging markets category for active managers. And that’s because they were strategic about their country allocation. So they were cautious with China and bullish with Brazil and those bets played out well in their favor,” says Calay.

Such trends continued in 2024: ranking European-based global emerging market equity funds by annual returns (as of September 9), in 17th position you find a first passive fund. Moreover, among the 50 (out of a total of 740) year-to-date best-performing funds, there are only four passive strategies, proving that in bear phases, the cautious approach of active managers can make all the difference.