By JLP | December 31, 2007
I received permission from Larry Swedroe to post this.
The performance of emerging market equities has attracted the attention of individual investors. From 1989 through 2005, while the S&P 500 Index returned 11.7 percent per annum, large-cap emerging market equities returned 13.5 percent per annum. In addition, the small-cap and value stocks of the emerging markets provided even higher returns, 14.3 percent and 17.7 percent, respectively. The difference in returns is more compelling if we look at just the last six years of the period, 2000–2005. While the S&P was losing 1.1 percent per annum, large, small and value emerging market stocks returned 8.5, 7.6, and 13.4 percent per annum, respectively.1
As we would expect, the marketing machines of Wall Street respond to the increased attention by rolling out new products. In 1991 there were just nine diversified emerging market funds listed in Morningstar’s database. By 2006 that figure had increased to over two hundred.2 The question an investor faces is: How do I choose from the wide array of choices? Because we believe that passive investing is the winner’s game, we think the answer is simple: You should choose one of the passive investment vehicles available to you, either the Vanguard Emerging Markets Index Fund, a comparable exchange-traded fund, or one of the three emerging market funds offered by Dimensional Fund Advisors (DFA), large, small, or value. DFA also offers an Emerging Market Core Fund that incorporates exposure to these three emerging market asset classes.
The question for investors is does the evidence support our beliefs? The study, “Predicting Emerging Market Mutual Fund Performance (Download),” looked at the question of how to choose an emerging markets fund. The authors examined if fund attributes such as expense ratios, portfolio turnover, manager tenure, recent past performance, fund size and the Morningstar mutual fund ratings can predict performance. They also examined if passive management outperforms active management. The following is a summary of their results:
- The only attribute that was able to significantly predict future fund performance was the expense ratio. The expense ratio was found to be generally negatively and significantly related to fund performance. Specifically, they found that lower fund expense ratios predict better future fund performance. This is exactly the finding believers in efficient markets expect to find.
- The majority of actively managed underperformed the Vanguard Emerging Markets Fund, a passively managed index fund. Again, the finding we expect.
The underperformance by the majority of actively managed funds was found despite the acknowledged presence of some survivorship bias in the data—a bias that produces artificially high returns because poorly performing funds disappear from the database. There is another bias in the data, however, that was not acknowledged. The passive benchmark used was the Vanguard Emerging Markets Fund. Using that index fund as the sole benchmark creates a problem of comparing apples to oranges. The hurdle for actively managed funds is simply too low. Let’s explore why this is the case.
The Vanguard Emerging Markets Fund is a large-cap fund. Just as is the case in developed markets, riskier small and value stocks produce higher returns than large-cap stocks over the long term. Thus actively managed emerging market funds that have at least some exposure to small and value have a tailwind at their back, making the comparisons look artificially favorable. We can see this bias at work by looking at the following table that presents the returns of the actively managed GMO Emerging Markets Fund and the aforementioned four passively managed funds. The period covered is the five years ending December 6, 2006.2 The important point to note is that the GMO fund is a value fund, while the Vanguard and DFA Emerging Markets Funds are large-cap funds.
GMO Emerging Markets
Vanguard Emerging Markets
DFA Emerging Markets
DFA Emerging Markets Small
DFA Emerging Markets Value
Note that if we use the Vanguard fund (a large cap fund) for the benchmark (as did the study) against which the GMO fund (a value fund) is judged, it looks as if the fund outperformed. However, when we benchmark the GMO fund against the appropriate passively managed benchmark (the DFA Emerging Markets Value Fund) the large outperformance (5.28 percent per annum) becomes a large underperformance (4.05 percent per annum). The GMO fund underperformed its appropriate benchmark. And since it is likely that at least some (if not most) of the actively managed emerging market funds in the study had at more exposure to small and value stocks than did the benchmark index fund, their performance is overstated unless you adjust for risk (exposure to size and value).
For taxable investors (and the preferred location is to own equities in taxable accounts) there is likely yet another bias in the data that favors actively managed funds. All the returns are pretax. The generally greater turnover of actively managed funds is likely to result in greater tax inefficiency, and, therefore, lower after-tax returns—the only kind we get to spend.
The evidence demonstrates that “active management in inefficient markets like small-caps and emerging markets is the winner’s game” is just another canard hoisted on the public by Wall Street. They need you to believe that myth because active management is the winning strategy for them (they collect large fees), while it is the losing strategy for you (you are likely to earn below benchmark results).
1 Fama-French return series provided by Dimensional Fund Advisors.
2 Aron A. Gottesman and Matthew R. Morey, “Predicting Emerging Market Mutual Fund Performance,” April 11, 2006.
Larry Swedroe is the author of Wise Investing Made Simple (2007), The Only Guide to a Winning Investment Strategy You’ll Ever Need (2005), What Wall Street Doesn’t Want You to Know (2000), Rational Investing in Irrational Times – How to Avoid the Costly Mistakes Even Smart People Make Today (2002), and The Successful Investor Today: 14 Simple Truths You Must Know When You Invest (2003), and co-author of The Only Guide to a Winning Bond Strategy You’ll Ever Need (2006) (All Affiliate Links). He is also a Principal and Director of both Research of Buckingham Asset Management and BAM Advisor Services — a Turnkey Asset Management Provider serving CPA-based Registered Investment Advisor (RIA) practices — in Clayton, Missouri (www.bamservices.com).
His opinions and comments expressed within this column are his own, and may not accurately reflect those of the firm.
It’s interesting how something can look good until it’s compared to something else. It’s kind of like the 6’0″ kid on the small town basketball team. He’s big until he has to go up against the 6’6″ players from a larger town.
Anyway, I appreciate Larry allowing me to post this. I hope to post some more of these in the future.
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