Swedroe: Active Underperforms In EM, Too

January 19, 2016

A recent article in The Wall Street Journal proposed that investors consider five factors before investing in emerging markets. One of these five factors was the flexibility of active funds. The author, Michael Pollock, writes: “Managers of active funds can make distinctions among that huge range of stocks that an index-tracking fund doesn’t make.”

The article quotes Jan van Eck, chief executive of Van Eck Global, who believes there are some compelling arguments for active management in an emerging markets fund. According to Van Eck, whose firm manages the Van Eck Emerging Markets Fund (GBFAX), with each of the countries in the category at a different point in its development cycle, “you absolutely don’t want to have exposure to all countries at all times.”

He goes on to add that “there are a lot of junky companies included in indexes.” Thus, “you want someone who can shift the company, [industry] sector and country exposure over time.” Van Eck concludes: “If you want to have one fund for emerging markets, active is the way to go.”

The EM Active Management Myth

This story about active managers and their ability to win in “inefficient markets” (such as emerging markets) is one I hear all the time. Unfortunately, like so much of what you read in the financial media, it is simply not true. And all one has to do is hold people accountable for their statements to show this is the case. With that in mind, we’ll turn to our trusty videotape.

The table below presents the Morningstar percentile rankings and returns for the actively managed GBFAX and the three passively managed emerging market funds run by Dimensional Fund Advisors (DFA) over the 15-year period (the longest Morningstar shows) ending Jan. 8, 2016. (In the interest of full discourse, my firm, Buckingham, uses DFA funds to construct client portfolios, and DFA is the fund family we use for emerging markets exposure.)


Fund 15-Year Returns
(%)
Morningstar Percentile
Ranking
Van Eck Emerging Markets (GBFAX) 5.4 87
DFA Emerging Markets (DFEMX) 7.7 40
DFA Emerging Markets Small Cap (DEMSX) 11.5 1
DFA Emerging Markets Value (DFEVX) 9.9 8
DFA Average 9.7 16

It’s pretty tough to make the claim that the emerging markets are inefficient when, during the most recent 15-year period, the passively managed DFA Emerging Markets Small Cap Fund finished in the first percentile of all funds. In addition, the firm’s emerging markets value fund finished in the 8th percentile, and its emerging markets fund finished in the 40th.

As for GBFAX, it underperformed DFEMX, DEMSX and DFEVX by 2.3 percentage points a year, 6.1 percentage points a year and 4.5 percentage points a year, respectively. In case you’re wondering, GBFAX also underperformed Vanguard’s Emerging Market Index Fund. For the 15-year period, the Admiral shares version of Vanguard’s VEMAX returned 7.4%, outperforming GBFAX by a full 2 percentage points a year.

DFA’s Funds Crush The Active Competition

Note that the three DFA funds had an average ranking of 16, which means that, on average, they outperformed 84% of actively managed funds, even before considering that Morningstar’s data doesn’t account for survivorship bias.

Given that about 7% of all funds disappear every year, the performance rankings listed above would have been much higher had the data been free of this bias. Also, given the typically higher turnover of actively managed funds, the DFA funds would likely have ranked even better on an after-tax basis.

There are four conclusions you can draw from the data:

  • Emerging markets are not the inefficient asset class active managers always seem to claim they are.
  • The costs of operating an emerging market fund and the costs of trading in the less-liquid markets of these countries are together so great that once costs, including taxes, are considered, active managers are highly unlikely to add value.
  • All that flexibility possessed by active managers in emerging markets is not the advantage they want you to believe. In fact, it has proven to be a disadvantage.
  • Passive management is most likely to prove the winning strategy.

The bottom line is that active management remains just as much a loser’s game in emerging markets as it is in developed markets. While it’s a game that’s possible to win, the odds of doing so are poor indeed.


Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.