Governance & Returns
In their study published in the 2015 Credit Suisse, Global Investment Returns Yearbook, Elroy Dimson, Paul Marsh and Mike Staunton examined the impact of screening out countries based on their degree of corruption. Countries were evaluated using the Worldwide Governance Indicators from a 2010 World Bank policy research working paper from Daniel Kaufmann, Aart Kraay and Massimo Mastruzzi, “The Worldwide Governance Indicators: Methodology and Analytical Issues.” The indicators comprise annual scores on six broad dimensions of governance.
Dimson, Marsh and Staunton found 14 countries that posted a poor score, 12 that were acceptable, 12 that were good and 11 with excellent scores. Post-2000 returns for the last three groups were between 5.3% and 7.7%. In contrast, the markets with poor control of corruption had an average return of 11.0%.
Interestingly, realized returns were higher for equity investments in jurisdictions that were more likely to be characterized by corrupt behaviors. As the authors note, the time period is short, and the result might just be a lucky outcome. On the other hand, it’s also logical to consider that investors will price for corruption risk and demand a premium for taking it!
We’ll now turn to Rekenthaler’s recommendation that you hire active managers if you’re going to invest in emerging markets.
Is Active Management The Answer?
One way active management could add value is by timing its entry and exit into emerging markets. How likely is that to show value added?
Here’s one bit of evidence that, at the very least, suggests there is a huge hurdle to overcome. From 1988 through 2018, the MSCI Emerging Markets Index (gross of dividends) returned 10.4%. The best 31 months of that 31-year period provided an average return of 12.5%, while the other 341 months returned 0.0%. The best 31 months (an average of just one month a year) provided more than 100% of the annualized returns. That would seem to make timing a daunting task. And keep in mind, Warren Buffett advises against trying to time markets.
The other way active management could add value is through stock picking and country selection, possibly combined with market timing. In its 2018 Annual SPIVA Scorecard, S&P found that 96% of actively managed funds in this supposedly inefficient asset class underperformed over the prior 15 years. And that is on a pretax basis.
Given that, for taxable investors, the greatest cost of active management is typically taxes—not the expense ratio—the odds of outperformance are even lower. I don’t like those odds.