Plagued by a combination of disappointing returns, heightened volatility, global trade wars, and (most recently) the COVID-19 crisis and regulatory uncertainty, emerging markets (EM) equities have been decidedly unpopular with many investors for years now. But during that time, the EM investment opportunity set has grown and expanded significantly, making EM equities fertile ground for investors seeking enhanced portfolio diversification and strong performance potential.
We believe differentiated actively managed investment strategies rooted in fundamental research are best positioned to access and capitalize on this attractive, but often-inefficient, asset class. In fact, we think investors who adhere to passive, benchmark-driven EM equity allocations may be missing out on full exploitation of the available opportunity set.
Here are seven reasons why, in our view, EM equity investors should favor active management, in spite of the potentially lower fees associated with passive implementation.
1. Passive EM equity exposure is a poor proxy for the structural opportunities. We believe the most powerful structural theme in EM, bar none, is climate change. Yet traditional EM equity benchmarks such as the MSCI EM Index remain heavily weighted toward carbon-intensive industries: energy, materials, basic manufacturing, etc. Another structural theme with comparable levels of underrepresentation in EM indices is health care.
2. EM equity beta is evolving rapidly, with potentially high rewards for active managers. The changes to the market composition of the EM equity space over the past 10 years have been dramatic and are continuing at a brisk pace. For example, traditional “old” industries are becoming less relevant amid thriving innovation and new business models. Forward-looking active investors can take advantage of these shifts.
3. Market inefficiencies in EM equity lead to more compelling alpha opportunities. One of the cornerstones of fundamental investing is that with a more inefficient market comes greater potential for alpha. This is certainly true in the EM equity universe, which is rife with idiosyncratic stock-specific opportunities and other inefficiencies that active managers can exploit in seeking to add value.
4. Relatively few stocks and themes tend to drive EM equity market returns. A study that was based on a broad sample of thousands of individual EM stocks showed that, from 1990 to 2018, only 37.6% outperformed one-month US Treasury bills on a buy-and-hold basis.1 To us, this underscores the potential benefits of active bottom-up research and discerning security selection to identify the “winners.”
5. IPOs are reshaping the EM equity landscape. The number of stocks listed on EM equity exchanges has risen meaningfully over the past five years (Figure 1). Many of these newer companies operate in potentially transformative industries (e.g., e-commerce, renewable energy, electric vehicles). This trend provides more investable opportunities, especially for active managers that can participate in companies’ initial public offerings (IPOs) ahead of their benchmark inclusion.
6. ESG creates opportunity for differentiated active insights via deep company research. Environmental, social, and governance (ESG) considerations are an increasingly important part of the investment framework for many asset classes. We believe investors with a sustainability orientation are best served by pursuing an active, research-intensive approach to bottom-up EM equity investing.
7. Finally, it is possible for active EM equity managers to generate alpha. “It’s impossible to generate alpha; so many active managers underperform.” This is a common refrain from clients that choose to invest passively in EM equity. However, the reality is that potential for alpha does exist. Some EM equity managers can and do consistently beat their benchmarks over time, highlighting the benefits of a rigorous manager selection process.
- Investing implications of a three-speed economy (July 2021)
- EM inflation has arrived, but will it stick around? (June 2021)
- A theme is not an index (June 2021)
1Hendrik Bessembinder, Arizona State University.