If active management is going to be effective in any equity category, it's emerging markets.
There should be market inefficiencies to exploit, given the lack of research on emerging stocks and wide dispersion between winners and losers, not least at the country level.
Yet assets are fleeing active emerging-market funds and rushing into exchange-traded funds (ETFs) instead. Data provider FactSet recorded a net $6.3 billion flowing into emerging-market ETFs in July, second only to US large-cap equities for the month, with a year-to-date net inflow of $11.6 billion.
This is not simply an indiscriminate rush into emerging-market equities, though.
According to the Investment Company Institute, almost $300 million was pulled from emerging-market mutual funds on a net basis in July. So far this year, a net $1.1 billion has been redeemed from these funds.
Bye active; buy passive
The recent performance of the active strategies to which investors are most exposed offers a clue to what lies behind this shift to passive products.
In July 2015, Citywire Discovery – a performance-tracking database – revealed 70.5% of all the assets in the emerging-market equity sector was in active funds, with a positive three-year information ratio.
By July 2016, the situation had completely reversed: only 31.7% of the sector’s assets were in funds with a positive three-year information ratio.
It seems unlikely that active emerging-market managers collectively revealed themselves as talentless – rather they were simply left behind by this year’s rally.
The MSCI Emerging Markets index lost 14.9% in dollar terms in 2015, its third consecutive down year. In the first half of 2016, the index gained 6.4%.
Investors, then, in their mass allocation to these ETFs, appear to be betting that emerging markets will finish the year strongly.
Index performance from July 31 2013 to July 31 2016
Anomaly of emerging incumbents
The wave of money hitting emerging-market ETFs has not been funneled equally, though.
July’s winner was the iShares MSCI Emerging Markets ETF (EEM), which attracted a net $4 billion. The only other emerging-market product in FactSet’s July top 10 was the iShares Core MSCI Emerging Markets ETF (IEMG), in ninth place with a net gain of $1.26 billion.
At face value, their respective positions are odd. EEM, launched in 2003, has an expense ratio of 0.69%. The ratio for the newer IEMG, unveiled in 2012, is 0.16%. For comparison, the Vanguard FTSE Emerging Markets ETF (VWO), launched in 2005, and has an expense ratio of 0.15% but did not make July’s top 10 sellers.
Why would anyone choose the more expensive ETF?
Dave Nadig, director of ETFs at FactSet, highlights the nature of the buyers as a possible explanation. He says EEM was a popular institutional trading tool because of its liquidity, while the VWO typically won flows from advisors.
‘This isn’t advisors coming back as much as it’s institutions and hedge funds,’ he says.
EEM’s 45-day average daily trading volume of $2.4 billion is far ahead of IEMG’s $234 million and VWO’s $568 million.
There are other differences too.
IEMG tracks a far broader index of emerging-market stocks, including small- and mid-caps, with 1,948 holdings in total; EEM has only 845 positions. VWO, meanwhile, uses a FTSE index, which excludes Korea from its emerging universe.
Yet despite the greater liquidity, and perhaps exclusion of smaller names too, it is surprising that EEM is so large, given its higher expense ratio. It currently holds $29.8 billion, up from $21 billion in August last year. The cheaper IEMG has grown more quickly over the past year, from $7 billion in August 2015 to $15.4 billion now, but is still only half EEM’s size. And VWO – the cheapest of the three – has in fact been shedding assets, from $53 billion in October last year to $42 billion now.
So while investors have been moving assets from active to passive emerging-market funds, they should perhaps also be reconsidering their allocations within ETFs.