Swedroe: Active Managers Fall Short In Emerging Markets

October 26, 2018

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.

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