The headline of a May article in Investment News, authored by senior columnist Jeff Benjamin, declares: “When investing in emerging-markets economies, stock picking beats indexed exposure.” As regular readers of my work will most likely not be shocked to discover, this assertion doesn’t reflect my own thoughts, nor is it supported by the historical evidence.
All in all, there was nothing particularly new in Benjamin’s article, which simply repeats the “conventional wisdom” Wall Street wants and needs investors to believe: that while indexing might be appropriate for informationally efficient markets (like U.S. large stocks), in informationally inefficient markets (like emerging markets), individual stock selection is the way to go.
Unfortunately, that idea is nothing more than what Jane Bryant Quinn called investment porn—shameless stories about performance meant to tickle our prurient financial interest, but without basis in fact.
With that in mind, I thought it was worth addressing some of the quotations in the article. Krishna Memani, chief investment officer of OppenheimerFunds, stated: “If you have a 10-, 15-, or 20-year horizon, it’s difficult to say developed will grow faster than emerging markets.” While that’s true, there are a few problems with that position.
The first problem involves the belief that this particular bit of information is value-relevant information. Ask yourself this: “If the market (investors in aggregate) possesses this information (and the fact that the economies of emerging market countries are likely to grow more quickly than the economies of developed market countries surely isn’t a big secret), is that information already embedded in prices?” Of course it is, and thus that knowledge has no value to you.
Markets Price For Risk
The second problem is that markets don’t price for growth. Rather, they price for risk. Informed investors are aware that growth companies, which tend to have faster rates of growth in earnings, have produced lower returns than value companies, which tend to have slower growth in earnings. In addition, there is a slightly negative relationship between the growth rate of a country’s gross domestic product and its domestic stock returns.
The article goes on to report that while Memani does offer a nod to broad market exposure through indexing strategies, he also says that for more reliable exposure, stock picking is better. He adds that investors with the time to do the research can’t go wrong (emphasis mine) when investing in economies associated with growth. There’s only one problem with those statements: There’s neither truth nor logic to them.
Even before examining some of the evidence, it’s pretty amazing to me that this myth about active management being the winning strategy in informationally inefficient markets persists despite the 1991 publication of William Sharpe’s brilliant short paper, “The Arithmetic of Active Management.”
Do The Loser’s-Game Math
Using simple arithmetic, Sharpe shows that active management, in aggregate, must be a loser’s game because, in aggregate, active managers must underperform proper benchmarks. Sharpe’s mathematical proof demonstrates this will remain true not only for the broad market, but also whether the market is in a bull or bear phase. Additionally, it must hold true for a subsector of the market, such as emerging market stocks.
Sharpe concluded: “Properly measured, the average actively managed dollar must underperform the average passively managed dollar, net of costs. Empirical analyses that appear to refute this principle are guilty of improper measurement.”