Since the first index fund was launched in the early 1970s, the concept of passive investing has come a long way in terms of earning respect. For broad U.S. equity mandates in particular, finding supporters of active management is getting tougher in the 21st century. And among those managers who claim to mint alpha relative to broadly defined benchmarks, such as the Russell 3000 and MSCI U.S. Broad Market Index, many track records look a lot less impressive after adjusting for size (market cap) and style (value).
But the case for indexing isn’t nearly so persuasive in other asset classes, or so the skeptics argue. In emerging markets, for instance, the argument is that equity trading is less efficient compared to the U.S. and so the opportunities for minting alpha are higher.
Does this claim stand up to scrutiny? No, according to Paul Lohrey, Vanguard’s chief investment officer for Europe. In a recent essay, he asserts that “the idea that investors in this asset class [emerging market stocks] are better off with actively managed portfolios should be challenged. Taken as a group, active managers fail to consistently add value to emerging market portfolios after expenses. In fact, over the past ten years, 81% of actively managed emerging market funds have underperformed the FTSE All-World Emerging Index.”
Of course, you’d expect someone from Vanguard to make such a claim. Indexing, after all, is the company’s bread and butter. That inspires looking at the numbers again, and courtesy of Morningstar’s Principia software, the task is quite easy.
There are 91 mutual funds and ETFs in Morningtar’s diversified emerging market equity category with three years of history through last month (our screen ignores various share classes for a given mutual fund). For the trailing 3 years through January 31, 2010, the annualized total returns range from a high of 8.1% down to a loss of 23.5%, the latter being a victim of leverage.
By contrast, a popular index in this space (MSCI Emerging Markets) posted a 3.5% annualized total return through last month. How many emerging market funds beat the index over the past 36 months? Twenty, or about 22% of the pool of funds with track records stretching back at least 3 years.
Perhaps three years isn’t a fair sampling of the historical record. Okay, let’s look at the trailing 10 years through the end of January. Over that run, MSCI Emerging Markets’ annualized total return is 9.1%. Meantime, there are 56 funds in Principia’s database with records at least that long. The range of returns for those 56 portfolios runs from a high of 14.8% to a low of 2.1%. As it turns out, 22 funds beat MSCI EM over the past decade, which means that nearly 40% earned benchmark-beating returns.
That’s better, but it still doesn’t make a strong case for thinking that generating alpha is easy or sommon in emerging markets. What’s more, similar results apply to the other major asset classes too. A relevant index that’s designed as a proxy for a broadly defined asset class tends to capture middling results if not slightly better than middling over time, depending on how much active managers in the space are charging.
You could, of course, spend a lot of time analyzing the expanding universe of actively managed funds. There’s no guarantee that you’ll hit pay dirt, although you’re sure to create a hefty workload. You’ll also pay more, perhaps much more, regardless of whether you earn more or not. All of these caveats are compounded if you plan on owning a multi-asset class portfolio, in which case you’ll have to pick superior managers across the array of capital and commodity markets.
Can it be done? Sure. But the real question is this: How much confidence do you have that you’ll be able to identify investment talent, in advance and in enough of your investments to rationalize paying the extra costs of active management, which can add up to as much as 100 to 200 basis points. Yes, some investors are able to pull this off, but the majority don’t. The tragedy is that the average investor often ends up with middling results at actively managed prices.
Maybe, just maybe, your time and effort is better spent at evaluating the betas and the overall asset allocation and deciding how and when to overweight/underweight via the lowest-cost index funds and ETFs. Yes, this is hard too. But you’ve got to make these strategic decisions even if you own active managers.
In fact, if you’re halfway successful in managing the asset allocation, the heavy lifting is already done. Superior choices in picking active managers can add incremental return in a multi-asset class portfolio, but not much. Unless you’re willing to make extreme strategic bets in the asset allocation, favoring active management probably won’t change your portfolio results other than to create a performance drag. That is, unless you’re in the top decile of the population when it comes to figuring out who’ll beat the index and who won’t.