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The Case for Active Management in Emerging Markets

When it comes to investing in emerging markets (EM), an active management strategy has many distinct advantages over a passive management strategy typically used by index-based investments.

Arguably, the debate surrounding active versus passive management – whether in emerging or developed markets (DM) - amounts to no more than a zero sum game, as either strategy has its own merits and pitfalls; and winners and losers.

The underlying truth is that active managers have the advantage of being “free to roam” in making their investment decisions compared to passive managers who are restricted to investing in an index over which they have no control.

The pitfalls of using broad-based indices

In the case of emerging markets, the argument for active management is even stronger because emerging markets are unique; they are not a homogenous asset class. To put this in perspective, one of the world’s largest index providers, S&P Dow Jones Indices, highlights the shortcomings of using a broad-based passive strategy to invest in emerging markets in its research report, Emerging Markets: What’s in your Benchmark?: “Not all emerging markets are created equal. Numerous factors, including country and regional combinations, can create vast differences in performance and return patterns. If you’re looking to boost returns through exposure to international markets, you may want to dig deeper and consider looking beyond traditional broad-based benchmarks to truly assess the value of an allocation to any of the world’s emerging economies.”i

In another report, Looking beyond Traditional Benchmarks to Add Value in Emerging Markets,ii S&P notes that although emerging markets have grown in size and importance and have become a core part of many portfolio allocations, the use of more complex asset allocation strategies remains extremely limited as the vast majority of investors continue to gain exposure to emerging markets via index-linked and benchmark tracking products. The report recommends that “while accessing emerging markets through a single holding linked to a conventional benchmark is an effective, low cost way to obtain unbiased exposure to this asset class, evidence indicates that a more discerning approach to manage emerging markets portfolios may potentially add value in the same ways it can in the US and other developed markets.” Such an approach, in our opinion is active management.

Ironically, in promoting the use of its specialized emerging markets indices, S&P clearly highlights the weaknesses of widely-used broad-based indices in emerging markets investing – which incidentally supports the case for active management in emerging markets.

There are several other reasons why an active strategy is more suited to investing in emerging markets.

  • Passive Strategies Overlook Faster Growing Smaller Companies

Arguably, the holdings of most index-based investments that focus on emerging markets are benchmarked to a broad-based index, such as the MSCI World Index. The problem is, such indices typically include only the largest stocks by market capitalization and exclude potentially faster growing small and medium cap stocks.

More importantly, a significant portion of emerging market stocks, roughly two-thirds, is excluded from the respective indices, which means that investors in index-based investments lose the opportunity to participate in their growth.

  • Indices Have a Sector Bias

Indices in emerging markets represent dominant sectors, which vary from country to country – which is especially true for capitalization weighted indices. In fact, sector weights vary widely across emerging markets. For example, the Asia-Pacific region has significant exposure to information technology, a sector that has virtually no representation in other emerging regions. On the other hand, Latin America and Emerging Europe have much higher weightings to energy and materials as these regions are home to natural resource rich countries such as Russia and Brazil.

  • Markets are not always efficient

Passive managers argue that the markets are efficient and that it is difficult to outperform an index. On the other hand, active managers believe that the markets possess mispricing opportunities which can be leveraged to outperform the index. In its research paper, The Merits of Active Management, BNY Mellon Asset Management suggests that “there are nearly always mispricing opportunities in markets, particularly for investors who are prepared to investigate asset markets thoroughly, and who are equipped to use long-term perspective.”iii The paper adds: “the efficient market hypothesis ignores the overwhelming importance of emotive behavior (fear and greed being the most obvious elements of such behavior) in investors’ decision making.”iv

  • Indices can pose greater risk

Active managers can take defensive action and sell the stock of a troubled company or make changes if they believe the market may decline but passive managers do not have the same degree of flexibility. Effectively, “passive investors can be hostages to the fortunes of troubled companies, even if they foresee those companies troubles.”v – as they have no control over security selection. As a result, passive managers have to endure index volatility to the detriment of investors, whereas active managers can make tactical shifts in asset allocation.

Indices can also present concentration risks which can result in greater losses should the fortunes of heavily weighted sectors take a turn for the worse. In the case of exchange traded funds (ETFs), investors may also face counterparty risk.

  • What you see is not what you get

Passive investors often mistakenly believe that their investment will yield exactly the same return as the underlying index or benchmark. However, passive investments such as ETFs and index funds can experience tracking errors which reduce the returns of the underlying investment. Such errors can result from several factors, including: cash drag which can cause variances in returns due to the time lag in holding and re-investing cash held by the product; the lag or discrepancy resulting from an ETF or index fund buying or selling illiquid securities on an index in order to replicate the portfolio’s benchmark; and the cost incurred from currency hedging in an international ETF.

  • Fees and costs vary

One of the biggest arguments against active management is higher fees. While true, it must be noted that fees and expenses vary widely for both active and passive management. In addition to trading costs, investors must also be aware of “hidden costs” associated with products like ETFs such as the spread between a security’s buying and selling price and the spread intrinsic in the pricing of ETFs themselves.

At the end of the day, investors need to look at the returns they receive relative to the fees they pay. In emerging markets, active managers have the potential to outperform their benchmarks. “In certain niche markets, like emerging market and small company stocks…it is possible for an active manager to spot diamonds in the rough,” states a Wharton, University of Pennsylvania article.vi Conversely, the performance of passive managers is dictated by the index.

The Excel Funds active management advantage

All of Excel’s Funds benefit from active on-the-ground management. Investors in Excel’s Funds collectively benefit from one of the largest knowledge base of on-the ground managers, comprising of over 400 portfolio managersvii who manage more than USD $1.6 trillionviii in assets. These managers live and breathe local conditions and use rigorous risk management processes to generate the highest possible long-term returns.

More importantly, the managers have first-hand knowledge of the companies in which they invest and can perform onsite visits and meet management teams prior to making investment decisions – providing them with a competitive edge over passive managers.

We at Excel Funds believe that emerging markets have unique characteristics and opportunities which makes on-the ground management a necessity. As a result of being on-the-ground, a significant portion of the holdings of Excel Funds are outside the index, which in the managers’ opinions represent the best opportunities for growth.

Case Study: Actively-managed Excel India Fund outperforms benchmark

In our opinion, generating superior risk-adjusted returns comes down to picking the right stocks in sectors with sustainable growth potential. It must be recognized that regardless of the market conditions, there will almost always be good growth stories within the universe of EMs through various market cycles. Capitalizing on such opportunities can only be achieved through active management.

Excel India Fund Total 3 Year Annualized Risk Adjusted Return Versus ETFs

Excel India Funds Total 3 Year Annualized Rick Adjusted Return Versus ETFs

Source: Bloomberg Total Annualized Return from 07/31/2012 - 07/31/2015 in CAD on the main series A of the respective funds Disclosure: Benchmark is based on MSCI India Index and MSCI India Small Cap Index. ETF return is based on iShare, Powershare, WisdomTree and BMO India based ETFs. Fund performance is based on Series A of the Excel India Fund.

Active, on-the-ground management is the primary reason why The Excel India Fund has outperformed its benchmark Sensex Index. As at July 31, 2015, The Excel India Fund was up 12.1%, (annualized since inception) outperforming the Sensex Index by 2.2% points (annualized over the last 17 years).

Excel India Fund Annualized Performance Since Inception

Since Inception Annualized Performance Excel India Fund

Source: Bloomberg. Hypothetical investment of $10,000 at the inception of the Excel India Fund Series A on April 15, 1998 to July 31, 2015 with distribution reinvested. CAGR is based on annualized total return in CAD. Past performance is not necessarily indicative of future returns.

Excel India Fund One Year Total Return

The Excel India Fund One Year Total Return

One year total return in CAD terms as of July 31, 2015

The Excel India Fund, the largest and longest running mutual fund in Canada solely focused on investing in India, is actively managed by award-winning Birla Sun Life Asset Management, one of the most respected asset managers in India.

Birla has a strong emphasis on in-house systematic research and uses rigorous risk management processes to generate solid investment returns. Birla also has first-hand knowledge of the companies in which it invests and can perform onsite visits and meet management teams prior to making investment decisions, giving it a competitive edge over passive managers.

As a result of being on-the-ground, Birla can identify the best growth opportunities in India, which are not necessarily part of the Index. In fact, 40% of the holdings in the portfolio of the Excel India Fund are outside the index which has contributed to the Fund’s outperformance.

Effectively, in emerging markets like India which have unique characteristics and opportunities, active management is necessary for finding pockets of value which have the best risk/reward characteristics. This is best done by picking the right stocks in sectors with sustainable growth potential, which are not necessarily part of the index.

 


 

  1. Emerging markets: What’s in your benchmark? S&P Dow Jones Indices, 2013
  2. Looking beyond Traditional Benchmarks to Add Value in Emerging Markets, S&P Dow Jones Indices, May 2013
  3. The merits of active investment management, BNY Mellon Asset Management, 2010
  4. ibid
  5. ibid
  6. Active vs. passive investing: Which approach offers better returns? Wharton, University of Pennsylvania, 2015
  7. Latest company figures available as of April 30, 2015
  8. Latest AUM figures available as of April 30, 2015

Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. Please read the prospectus before investing. Mutual funds are not guaranteed, their values change frequently and past performance may not be repeated. This document may make forward-looking statements and there are risks that actual results could differ materially from forecasts, projections or conclusions in the forward-looking statements. Certain material factors and assumptions were applied in drawing the conclusions or making the forecasts or projections in the forward-looking statements and you may find additional information about such material factors and assumptions and the material factors that could cause actual results to so differ from the sources provided. The above information should be considered as background information only and should not be construed as investment or financial advice. Further, it should not be construed as an offer or solicitation to buy or sell securities. The information contained in this document is for informational and illustrative purposes only and is not intended to provide specific financial, investment, or other advice to you, and should not be acted or relied upon in that regard without seeking the advice of a professional. Particular investments or trading strategies should be evaluated relative to each individual.

Disclaimer

Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. Please read the prospectus before investing. Mutual funds are not guaranteed, their values change frequently and past performance may not be repeated.