Is an active investing approach doomed for emerging markets?

Almost 75% of the total flows going into emerging market equity funds have been allocated to index-tracking options. In the latest monthly column, a Morningstar analyst considers the active versus passive debate for exposure to the fastest-growing economies. 

The flows picture for the European investment fund market in the first four months of 2023 reveals a budding risk-on sentiment after the woeful experience of 2022. In particular, emerging markets are experiencing a healthy revival.

Investors have been encouraged by China’s decision to scrap its zero-Covid policy to allow for a full reopening of its economy, as well as the easing of tensions in international energy markets despite the ongoing conflict between Russia and Ukraine.

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Also, importantly, emerging markets were broadly insulated from the problems affecting the US and European banking sectors. And to cap it all, the assumption is that emerging markets, having started their monetary tightening cycle well ahead of developed countries, should now be poised to start changing gears, which supports their growth prospects.

Emerging markets and China in demand

Flows into European-domiciled emerging market equity funds amounted to €15.5 billion (£13.4 billion) to the end of April and were the third-highest flow-gathering Morningstar category over the period, only surpassed by global large-cap equity and fixed-term bonds.

But in addition to broad emerging market exposure, investors also made a beeline for single Chinese equity exposure, both A-shares - stocks that trade either in the Shanghai or Shenzhen exchanges – and offshore. Flows into the China equity A-shares Morningstar category totalled €3.2 billon, while Chinese offshore equity funds gathered €2.7 billion.

Passive funds have been the vehicle of choice for most European investors so far this year, and this has also been the case to gain exposure to emerging markets equities. Almost 75% of the total flows going into geographically broad-based emerging market equity funds have been allocated to index-tracking options.  

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In addition, the top-10 flow-gathering funds in the category out to the end of April were all passive vehicles – traditional index funds and exchange-traded funds (ETFs). Topping the classification were Vanguard Emerging Markets Stock Index, the iShares Core MSCI Emerging Markets IMI ETF (LSE:EMIM) and the UBS (Lux) MSCI Emerging Markets ETF. They all carry a Morningstar Medalist Rating of Bronze.

Do active funds have an edge in emerging markets?

The growth of passive investing probably no longer comes a surprise, but some may raise an eyebrow at the fact that index-tracking vehicles are also being favoured to such a great scale to gain exposure to markets that are routinely highlighted as prime territory for active management. Indeed, I can’t count the times I’ve been to debates pitching proponents of active and passive investing against each other and have heard that “passive investing is fine for highly liquid markets but inefficient for trickier exposures such as emerging markets where the value of active management still counts”.

Theoretically, there are several reasons why passive funds may not be the optimal option for allocating your money to in emerging markets equities. For a start, emerging markets face greater geopolitical risks, and thus volatility, than their developed counterparts.

Moreover, standard equity indexes for this asset class, such as the MSCI Emerging Markets (EM) Index, typically come with geographical and sector biases that could be exploited by experienced active managers to add value.

For example, the MSCI EM Index offers exposure to 24 countries, but in effect it concentrates half its portfolio in just four countries, namely China, Taiwan, India and South Korea. The underperformance of any of these could drag the entire index down. This is a weakness of a rules-based and broadly inflexible index-tracking investment approach and something that active managers could avoid by altering country allocation weights in their portfolio.

The theory is one thing, but how it translates in practice is another. Morningstar’s European Active/Passive Barometer – a report that measures the performance of active funds against passive peers in their respective Morningstar categories – shows that active global emerging markets equity managers encounter challenges comparable to those faced by their peers in developed equity categories.

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Most notably, the compounding benefits of low management fees are a powerful tailwind for passive funds. This, in conjunction with poor investment decisions, means that a significant number of active funds fail to survive over periods over five years. This automatically enhances the success rate of a standard index-tracking investment approach.   

Is this to say that an active approach is inevitably doomed for emerging markets? No, it simply says that picking a successful active manager in this category is also challenging. As investors become more aware of this reality, they are likely to choose the simple, low-cost passive investment option.

Jose Garcia-Zarateis associate director of manager research Europe, the Middle East and Africa, at Morningstar.