Active management has come under increased scrutiny by investors, largely due to the rise of low-cost passive products which have provided cheap equity exposure during the recent, decade-long bull market. But with the extreme levels of market volatility this year, some investors are starting to reconsider active management to navigate through the volatility and provide downside protection.
Not all equity markets are the same, with some being less efficient than others, and it is in these less efficient markets that active management has a better chance of success. To try and shed some light on this, I compare two markets which often make their way into an investor’s portfolio, the US and Emerging equity markets, by looking at some big picture measures of efficiency.
But before going into that, it’s useful to see what these markets look like. The below table gives an overview of the main indices which are typically used as benchmarks.
Source: Bloomberg, MSCI. Date: May 2020.
Now for the comparisons…
How well are stocks covered?
The first measure considered is stock coverage, where a ‘covered stock’ is one which a sell-side analyst publishes research and recommendations on. We assume stocks with higher coverage are more efficiently priced as they are better understood by the market.
To incorporate more of the investable universe, it is better to use broader indices that include the smaller end of the market and are therefore more reflective of the actual universe available. I use the MSCI US Broad Market Index and the MSCI Emerging Markets Investable Market Index (IMI), which each consist of around 3,000 stocks and represent approximately 99% of the free float-adjusted market.
The chart below indicates that there is reasonable stock coverage even at the smaller end of both markets (RHS). Interestingly, and at the smaller end of the market in particular, there is actually more analyst coverage in Emerging Market names than in the US, which goes against the typical view around how closely followed the US indices are. However, whilst it plots the number of sell-side analysts making stock recommendations, it says nothing about the quality of each recommendation and also does not incorporate buy-side coverage. As a result this doesn’t necessarily mean more efficiency in EM but shows that the picture may not be as clear as typical perceptions.
The conclusion? Neither market can be said to be under-researched. This makes active management more challenging as a unique perspective is required to generate alpha rather than just having better resourcing than other market participants.
Source: Bloomberg, MSCI, Redington. Date: January 2020. Chart also shows cumulative stock weights; the US is a more concentrated market.
Who owns the stocks?
The next data point to consider is stock ownership. The US equity market is dominated by institutional and other investors with negligible government ownership on a market cap-weighted basis. This widespread institutional ownership lowers the potential for securities to be mispriced, as we assume the majority of institutions are efficient economic agents acting rationally on public information (though the more granular breakdown to include individual or retail investors is ignored here).
EM equity is predominantly owned by Private or Institutional Investors too, however government ownership is more prevalent. Greater state ownership increases the potential for mispricing as governments often hold securities for reasons other than their prices, so active management may be more relevant here based on this. This market inefficiency is an opportunity for sophisticated investors with clear, proven investment philosophies to find good companies.
Source: Bloomberg. Date: January 2020. “Government ownership” refers to direct equity stakes only, likely underestimating total state ownership.
How volatile are the markets?
The third metric to think about is return volatility. Greater volatility implies there is less efficient pricing, as companies’ intrinsic values do not change that significantly from month to month, and there is therefore more opportunity for an active manager to benefit from temporary mispricing.
The following table and chart show that Emerging Markets have consistently experienced a greater volatility in returns, in almost every month since inception on a one-year rolling basis. This is further evidence to suggest that active management is better suited here.
Source: eVestment. Date: April 2020.
How have active managers done?
A final measure to look at is cumulative excess returns (over the relevant benchmark) for actively managed funds. If active funds in aggregate are consistently delivering returns above the market benchmark (which can be replicated passively), this implies there may be some market inefficiencies that active managers are exploiting. Based on a relevant (long-only, all-cap) set of active funds, I find the median 10-year, cumulative excess return to be 23.9% in EM compared to 12.3% in the US. This implies active managers have more success versus the passive benchmark in EM than in the US, though it’s worth noting that both datasets will contain a degree of survivorship bias.
In terms of implementation, the US has a greater 10-year excess return dispersion as shown in the charts below, suggesting there is a higher potential benefit from selecting good managers in the US than in Emerging Markets. However, it should be noted that there are more US strategies in the database used here (880 vs 194 in EM) which could explain the broader range of excess return.
The dispersion is still significant in both datasets and shows the value that can be added from a strong manager research process.
Source: eVestment. Date: December 2009 – 2019. Data: top and bottom quartiles of 880 managers (US) and 194 managers (EM) displayed.
A final note on fees
US active managers have lower fees on average than active EM managers. This could be due to competition in the manager market driving down fees in the US, whereas EM managers likely require wider (thus costlier) resourcing to cover different countries, meaning there are fewer incumbents and so less competition. Greater liquidity in the US supporting higher fund capacities may also play a role.
Source: Financial Express. Date: January 2020. TER comprises custody, fund administration and all standard legal expenses, tax return preparation, fund audits and tax reclaim efforts.
The verdict
We can cautiously conclude that Emerging Markets have greater scope for active management. Stock ownership is more governmental, the market more volatile and the median active manager has delivered better excess returns. It’s also worth noting the heterogeneity between the 26 EM nations, which an active manager with good resourcing can appreciate, developing a nuanced understanding of regional complexities and translating this into return.
However, there appears to be slightly less sell-side coverage in the US market and there is greater dispersion in active managers’ returns, which eludes to the opposite conclusion. Whilst these two observations have their caveats, all we can really say for sure is that it is not as clear cut as people make it out to be.
Sources: Bloomberg, eVestment, Financial Express, MSCI. Currency: USD. *EM countries include: Argentina, Brazil, Chile, China, Colombia, Czech Republic, Egypt, Greece, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Pakistan, Peru, Philippines, Poland, Qatar, Russia, Saudi Arabia, South Africa, Taiwan, Thailand, Turkey and United Arab Emirates.
