Tuesday, September 13, 2011

Passive Management Wins in Emerging Markets

I was recently asked about the performance of funds run by Mark Mobius, who has been called a global pioneer by BusinessWeek. Mobius made his mark in emerging market funds, so it got me thinking about the performance of active emerging market funds as a whole. As it turns out, the picture isn’t pretty.
First, let’s see how Mobius has performed. Keep in mind that Asiamoney named him as one of the Top 100 Most Powerful and Influential People in 2006, stating that he “boasts one of the highest profiles of any investor in the region and is regarded by many in the financial industry as one of the most successful emerging markets investors over the last 20 years.”
The first thing I did was to go back to an analysis I did on active management in emerging markets covering the 10-year period ending in 2006. For that period, Templeton Developed Markets (TEDMX) returned 8.7 percent per year. This compared with a 10.2 percent return per year for the DFA Emerging Markets Portfolio (DFEMX) and a 9.3 percent per year return for the Vanguard Emerging Markets Fund (VEIEX).
The next step was to update the data. The following are the returns for the 10-year period ending August 30, 2011.

Mobius also runs the Templeton Emerging Markets Small Cap Fund (TEMMX), which has an inception date of Oct. 2, 2006. For the three-year period ending August 30, 2011, the fund returned 9.1 percent. By comparison, the DFA Emerging Markets Small Cap Portfolio (DEMSX) returned 12.7 percent, outperforming TEMMX by 3.6 percent.
A very persistent investing myth is that active management is the winning strategy in so-called inefficient markets (such as small-caps and emerging markets. As my colleague Vladimir Masek put it: “If the ‘active camp’ is right, and bright, experienced, hard-working managers like Mobius can take advantage of market inefficiencies, then we should see them outperform market benchmarks by wide margins in the most inefficient markets, for example in emerging markets.”
The evidence presented can’t tell us how bright or hard-working Mobius is, as we know he’s both. Instead, it can tell us which camp is more likely to be right. More supporting evidence would make the case stronger, so now we’ll broaden our look to include a wide universe of emerging market funds.

To provide further evidence, I went back to a study I did in 2007 on the performance of emerging market funds versus passive alternatives. The table below provides 10-year returns through August 30, 2011. By reviewing the performance of the funds that were on the 2007 list, we can identify if survivorship bias is tainting the data. It turns out there’s plenty of bias. Several funds on the 2007 list no longer exist. For example, the Invesco Van Kampen Emerging Markets Fund was merged out of existence in April 2011. Others that no longer appear to exist are:
  • Eaton Vance Emerging Markets Fund
  • TCW Emerging Markets Equity Fund
  • Seligman Emerging Markets Fund
  • Credit Suisse Emerging Markets Fund Common
  • AIM Emerging Markets Fund
Funds with good performance aren’t sent to the mutual fund graveyard. So we have six dead funds from the list of 37 active funds that had 10-year track records as of the end of 2006.
Of the remaining 31 funds, both DEMSX and the DFA Emerging Markets Value Portfolio (DFEVX) outperformed every single one. Only nine (29 percent) outperformed DFEMX, and only 10 (32 percent) outperformed VEIEX. The average surviving actively managed fund returned 14.7 percent, underperforming DFEVX by 5.2 percent, DEMSX by 4.8 percent, DFEMX by 0.9 percent and VEIEX by 0.3 percent. Accounting for survivorship bias would only make the evidence more compelling.

William Sharpe demonstrated in his famous paper The Arithmetic of Active Management that passive management being the winner’s game doesn’t depend on market efficiency. Instead, it depends on the simple laws of mathematics, or what John Bogle calls The Cost Matters Hypothesis. Since all emerging markets stocks must be owned by someone, and passive investors earn the market returns less low costs, and in aggregate, active investors must also earn the market return less high costs, in aggregate passive investors must earn higher net returns than active investors.

No comments:

Lunch is for wimps

Lunch is for wimps
It's not a question of enough, pal. It's a zero sum game, somebody wins, somebody loses. Money itself isn't lost or made, it's simply transferred from one perception to another.