Swedroe: Active Managers Fall Short In Emerging Markets

Talk that active management in inefficient markets such as emerging markets is a myth.

Even many devotees of active portfolio strategies have conceded that the efficiency of the market for U.S. large-cap stocks is so great that attempting to add value—or generate alpha—through active management is highly unlikely to produce positive results.

However, one of the more persistent myths perpetuated by both Wall Street and the financial media is that active management is the winning strategy in so-called inefficient markets—with emerging markets often cited as the most inefficient market.

Let’s debunk that myth right now. To demonstrate that active management is just as much a loser’s game in the supposedly inefficient emerging markets, I’ll examine the returns of all the surviving actively emerging market funds with a 20-year track record (from September 1998 through August 2018). Note that the data will have significant survivorship bias.

Morningstar’s database provides us with a list of just 39 actively managed funds and four passively managed funds (i.e., no individual stock selection or market timing). The four passive funds are Vanguard’s Emerging Markets Stock Index Fund (VEIEX) and three structured portfolios from Dimensional Fund Advisors: DFA Emerging Markets I (DFEMX), DFA Emerging Markets Small Cap I (DEMSX) and DFA Emerging Markets Value (DFEVX). (Note that I excluded one Dimensional fund, Emerging Markets II, DFETX, which is a lower cost version of DFEMX, as it has less than $70 million of assets compared to DFEMX, which has close to $6 billion.) Full disclosure: My firm, Buckingham Strategic Wealth, recommends Dimensional funds in constructing client portfolios.

Summary Of Findings:

• Annualized returns ranged from the 14.1% earned by the Oppenheimer Developing Markets Fund A (ODMAX) to the 5.9% earned by the ICON Emerging Markets Fund S (ICARX).
• VEIEX returned 10%, outperforming 24 (62%) of the 39 active funds. However, six of the 15 that outperformed were emerging market value funds. Thus, a more appropriate benchmark for those funds would be DFEVX. Excluding those six funds, VEIEX outperformed 24 (72%) of the 33 other actively managed funds.
• DFEMX returned 10.8%, outperforming 27 (69%) of the 39 active funds. However, four of the 12 active funds that outperformed were value funds. Excluding those four funds, DFEMX outperformed 27 (77%) of the 35 other actively managed funds.
• There were nine actively managed value funds in the emerging markets category. DFEVX returned 13.3% per year, outperforming all nine (by an average of 3.2%age points), and all but two (95%) of the entire universe of actively managed emerging market funds.
• DEMSX returned 13.1% per year, also outperforming all but two (95%) of the entire universe of actively managed emerging market funds. This is of particular note, because if emerging markets are inefficient, the most inefficient part is supposedly the small stocks. Yet a portfolio that engaged in neither stock picking nor market timing, just having bought all the stocks that are in its defined eligible universe, outperformed all but two actively managed funds.

Survivorship Bias

Again, it’s important to remember that all of the results are heavily biased in favor of active management due to the survivorship bias in the above data—funds that outperform don’t disappear.

Once we consider survivorship bias, the failure of active management becomes that much more “impressive.” The Morningstar database includes 87 actively managed funds that were available in September 1998. That’s 48 fewer than the 39 actively managed funds with 20‑year track records whose performance we analyzed.

Because actively managed funds that outperform don’t shut, we can be highly confident that all 48 no longer available underperformed. Thus, VEIEX’s ranking of 15/39 relative to the actively managed universe that survived is misleading.

Tough Odds

The right way to think about VEIEX’s ranking is 15/87. Thus, instead of outperforming 62% of the actively managed funds, it actually outperformed 83%. And if we excluded the actively managed value funds, the ranking would be even higher. Correcting for the survivorship bias, both DFEVX and DEMSX outperformed 98% of the actively managed funds, not 95%. I don’t know about you, but I don’t like odds of 98% working against me.

For supporting evidence, we can look to the S&P Dow Jones Indices SPIVA scorecards. The benefit of doing so is that they are free of survivorship bias. The latest SPIVA scorecard, from midyear 2018, showed that for the last five-, 10- and 15-year periods, 86.2%, 86.3% and 94.4%, respectively, of actively managed, publicly available emerging market mutual funds underperformed their benchmarks.

While all the above evidence demonstrates it’s a myth that active management is the winner’s game in the so-called inefficient markets, you don’t need the efficient markets hypothesis or the evidence to know that active management is the loser’s game in both inefficient and efficient asset classes. All you need is what John Bogle called the “costs-matter hypothesis.”

Costs-Matter Hypothesis

William Sharpe demonstrated in his famous paper, “The Arithmetic of Active Management,” that the winner’s game of passive management doesn’t depend on market efficiency. Instead, it depends on the simple laws of mathematics—the cost-matters hypothesis.

Because all stocks (whether small-caps or emerging market stocks) must be owned by someone, and passive investors earn the market returns less low costs and in aggregate, active investors earn the same market returns less high costs, in aggregate, passive investors must earn higher net returns than active investors. And while it’s possible emerging markets are less informationally efficient, the costs of implementing active strategies are also greater.

It’s also important to remember that all the data provided are based on pretax returns, and the greatest cost of active management for taxable investors is typically taxes. Thus, the evidence would almost certainly be much stronger if we looked at after-tax returns.

Summary

The bottom line is that active management is just as much a loser’s game in emerging markets as it is in U.S. large-caps. It’s a game that, while possible to win, the odds of doing so are so poor that it isn’t prudent to try.

Importantly, no one has found a way to identify which few active funds will manage to outperform in the future, as there is no evidence of persistence of outperformance beyond the randomly expected. Just like roulette or craps, the surest way to win a loser’s game is to not play.

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