Swedroe: Mythical Emerging Market Returns

June 29, 2015

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.

 

Baseless Assertions

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.”

 

 

In terms of specific evidence, a recent study by the research team at Vanguard found that once survivorship bias is accounted for, 71 percent of emerging market funds underperformed the average return of a low-cost index fund over the 10-year period ended 2013.

 

Furthermore, Morningstar provides a percentile ranking for mutual funds across asset class categories. If active management actually was the winner’s game in emerging market stocks, we shouldn’t expect Vanguard’s Emerging Markets Stock Index fund and the passively managed funds from Dimensional Fund Advisors (none of which engage in active management strategies such as the selection of individual stocks or market timing) to achieve relatively high rankings. (Full disclosure: My firm, Buckingham, recommends Dimensional funds in constructing client portfolios.)

 

How They Stack Up

The percentile rankings below are based on the 15-year period ending May 28, 2015. The 1st percentile is the best score and 100th is the worst.

  • Vanguard Emerging Markets Stock Index Fund (VEIEX): 38th
  • DFA Emerging Markets Fund (DFEMX): 39th
  • DFA Emerging Markets Small Cap Fund (DEMSX): 4th
  • DFA Emerging Markets Value Fund (DFEVX): 12th

 

The average ranking for the four passively managed funds is the 23rd percentile. Thus, on average, the funds outperformed 77 percent of the other funds in their category. Despite Memani’s statement, investors in well over 77 percent of emerging market funds did go wrong.

 

In fact, the figure is likely much greater than 77 percent because the data is heavily impacted by survivorship bias. Approximately 7 percent of all funds (the poorly performing ones) disappear every year. Thus, the actual rankings for the Vanguard and DFA funds would almost certainly be much higher if survivorship bias was accounted for.

 

An Expensive Myth

Morningstar also reports that the average surviving fund in this category returned 8.5 percent annually in the 15-year period over which these funds were ranked. VEIEX returned 9.0 percent, DFEMX returned 8.9 percent, DEMSX returned 11.7 percent and DFEVX returned 11.0 percent. The average return of the four passively managed funds was 10.2 percent, or 1.7 percentage points higher than for the average fund. Believing in the active management myth has been expensive indeed.

 

It’s also important to keep in mind that the Morningstar rankings are based on pretax returns. The higher turnover (and resulting lower tax efficiency) of actively managed funds would make the situation look even worse for active managers.

 

As a further test of the likelihood for actively managed funds to outperform in supposedly informationally inefficient asset classes, we can take a look at the rankings of DFA’s International Small Company Fund (DFISX) and their International Small Cap Value Fund (DISVX). Their percentile rankings were 7th and 1st, respectively.

 

The evidence makes it clear that the real question is not whether active managers are likely to win in emerging markets (or other informationally inefficient markets), but why this myth persists. I believe financial myths, such as this one, continue because it’s in the economic interests of the industry to keep them alive, and most investors are unaware of the evidence.

 

Knowledge is the armor that can protect you.


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

 

 

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