In an article last week, I wrote how I was asked to speak at the recent FE Trustnet Select Event on Emerging Markets and Asia Pacific ex Japan, which was attended by groups such as Baillie Gifford, Hermes and BNY Mellon as well as delegates like Rowan Dartington Signature’s Tim Cockerill, Whitechurch’s Ben Willis and Charles Stanley Direct’s Rob Morgan.
My presentation was based on some of the most interesting themes we discovered when writing about emerging markets in the past, the first of which was that they haven’t been this area of outstanding long-term outperformance that many people have believed them to be.
The second point is just as important, though, and that is that emerging markets have tended to be a very poor hunting ground for the ‘average’ active manager.
FE Trustnet has written about this subject in the past, but it is certainly worth revisiting the figures.
According to FE Analytics, for example, the IA Global Emerging Markets sector has underperformed against the MSCI Emerging Markets index over one, three, five, 10, 15 and 20 years.
Source: FE Analytics
It makes for even worse reading when you drill down a little further, given that just 23 per cent of IA Global Emerging Market funds with a long enough track record have managed to beat the index over the past decade.
That means it has been the worst performing regional equity sector in the Investment Association universe in that respect, as even 32 per cent of active funds in the IA North America sector (which is commonly viewed as the best peer group to go down the passive route) have managed to beat the S&P 500 over the past 10 years.
Source: FE Analytics
On top of that, just 11 per cent of funds have beaten the index in seven or more of the last 10 calendar years while 70 per cent have underperformed in the index in six or more years.
But why has that been the case? Certainly, emerging markets encompass a huge variety of regions, economies and stocks so it seems like an area where active managers should be able to add value if they do their research.
The MSCI Emerging Markets index covers 23 different countries and close to 900 companies, so investors could be forgiven for thinking it is a stock-picker's paradise.
From my point of view, there are a number of reasons why that the ‘average’ active fund has struggled against the index.
Personally (and I’m sure many of you would agree), I think there are a number of funds in the sector that probably shouldn’t exist. A large proportion of the peer group’s constituents are very small, seemingly make no active bets against the benchmark and, despite that, are very expensive.
We did a bit of digging into this and by looking through the major fund platforms we found that the ‘average’ fund in the IA Global Emerging Markets sector has a clean ongoing charges figure (OCF) of 1.26 per cent.
As a point of comparison, the average OCF in the IA UK All Companies sector is 24 basis points lower at 1.02 per cent. 
Simon Evan-Cook, senior investment manager at Premier and another delegate who attended the event, says there are a number of other reasons why the ‘average’ fund has struggled in the IA Global Emerging Markets sector.
“In the large part, emerging market investors tend to be quite over excitable and will focus on the big growth themes (as emerging markets are seen as this area of fantastic growth) and will there focus on the highest growth stocks within the highest growth regions, but will often be paying up a high valuation for that growth,” Evan-Cook (pictured) said.
“Now, that hasn’t proved to be a good strategy for outperformance in any sector in the past. Those funds which have done very well over the long-term (and I’m talking about the likes of Aberdeen and First State) have done so with a sharp focus on valuation and by not chasing ‘exciting’ high growth stocks.”
“Through a sort of Darwinian process, they have managed to stick around and build up a strong asset base.”
Evan-Cook also notes that it comes as little surprise that the ‘average’ fund in the IA Asia Pacific ex Japan sector has fared far better than their peers in the wider emerging markets sector.
Some 55 per cent of active funds in the sector have beaten the MSCI AC Asia Pacific ex Japan index over 10 years while the sector average has beaten the index over one, three and 10 years and he says that is largely because they have a more focused selection of stocks and regions to choose from, while emerging market managers may almost have too much of a selection.
Now, many investors may think that given how the ‘average’ global emerging markets fund has performed, they should just focus on passively managed portfolios.
Certainly, when you have the likes of the Vanguard Emerging Markets Stock Index which has outperformed the sector average since its launch in June 2009, had a tracking error of just 0.5 per cent over that time and charges only 0.25 per cent, why wouldn’t you?
Performance of fund versus sector and index since launch
Source: FE Analytics
However, despite all my references to the ‘average’ fund, it must be pointed out that such an entity doesn’t exist. Any talk of the ‘average’ fund normally comes in during the depths of an active versus passive debate, with many studies suggesting it underperforms over the longer term.
But, no investor wants average performance (whether or not that is through an active or passive fund), they want the best funds out there. Also, while I do believe there are some fairly woeful active funds available to investors, I am also a fan of active management and I do think it has a role to play within a portfolio.
Interestingly, FE data also shows that emerging markets have actually been area where fund selection has paid off.
For example, according to FE Analytics, the top 10 per cent of performers in the IA Global Emerging Markets sector over the past decade have returned 152.37 per cent which is some 60 percentage points more than the index’s gains.
Performance of best and worst GEM funds versus index over 10yrs
Source: FE Analytics
In addition, the best performers have outperformed the bottom 10 per cent of the sector’s performers by a hefty 115 percentage points over the period in question – which is a much larger spread than you would find in many developed market sectors.
While we are talking about the ‘average’, data suggests the ‘average’ investor in the sector has actually had a relatively good time in emerging markets over the past 10 years.
That it because those top performing funds account for 30 per cent of the sector’s total assets. Though those figures are as of today, looking back and the likes of Aberdeen Emerging Markets Equity and First State Global Emerging Markets (which are included in that equally weighted portfolio) were amongst the largest in the peer group 10 years ago.
Those worst performing funds, however, were small 10 years ago and today only account for 3.4 per cent of the sector’s assets today – which suggests that few investors have been exposed to that level of underperformance.
It’s also worth noting that we are heading for a new era for active management in emerging markets following a number of high profile soft-closures in the sector over recent years (such as Aberdeen and First State’s offerings).
All told, it means that 45.8 per cent of the money in the IA Global Emerging Markets sector is now in closed or tracker funds. While many investors may be happy to just keep hold of their existing assets in closed funds, for groups wanting to attract new money, there is certainly a gap in the market.
Of course, while certain active funds in emerging markets have managed to go against the grain and considerably outperform, (as we all know) the past is no guide to the future and investors who want exposure to the sector now need to try and find the funds that have the ability now go on and outperform.
To try and help them out, in an article later this week we will look at some of the bright and upcoming fund’s in the sector which although might not have the longest of track records, are highly rated and have demonstrated an ability to beat in the index over recent years.
