Investing in Emerging Markets

When it comes to the active vs. passive investing debate, to me, it’s a no-brainer: I’m a passive guy.

My entire portfolio consists of a couple of broad-market stock index funds and a bond fund. I don’t own any individual stocks and zero funds that try to beat the market. I stay invested in good times and bad and I ignore my portfolio as much as possible, except for annual rebalancing. (In practice, this means I look at it once a week. Thanks a lot, Mint.)

I invest this way not (just) because I’m lazy, but because I believe the evidence is overwhelming that a passive approach will outperform the vast majority of active investing strategies over time. Yes, over any given period, some active funds will outperform by a little and a select few will outperform by a lot — they’ll sail through a bear market smelling like honey.

Unfortunately, it’s impossible to know ahead of time which will be the winning funds and you might end up selecting one of the big losers. Oh, and index funds cost less. That means more money for me and less for a money manager.

As Rick Ferri puts it in his book The Power of Passive Investing, “There’s only a low probability that any fund will achieve superior returns. While it’s possible, it’s not probable.”

Or take it from author Bill Bernstein: “The debate between active and passive management is like the debate between astrology and astronomy,” he said in a recent interview.

As you can tell, I’m convinced of the superiority of index funds and passive investing to the point of smugness, so I thought it would be good for me to talk with someone who fundamentally disagrees. Jerry Webman is the chief economist at OppenheimerFunds and author of the new investing guide MoneyShift: How to Prosper from What You Can’t Control. He dedicates an entire chapter of his new book to building an intelligent argument against my style of investing, and the book is witty and engaging.

Webman and I didn’t have time to hash out the entire classic active/passive investing debate, so I wanted to focus on one of his favorite topics: emerging markets. These markets now account for about one-quarter of the stock market wealth outside the U.S., and we both agree that it’s important for a portfolio to own stocks from emerging economies like Brazil, India, and China. We disagree about the best way to do it, though.

An emerging discussion

MoneyShift argues that most investors, including index fund investors, are missing out on buying opportunities in emerging markets. “Emerging markets is one of the places where it’s easiest to make the case for bottom-up active management,” Webman told me. “You really do have many companies that are not carefully followed, maybe not well-understood, and a careful manager takes the time to figure out what the real market for the company is, and how they fit with the regulatory environment in which they have to work, which might not be fully evolved.”

“It would be foolish to surrender the emerging markets portion of your portfolio to a dumb index fund,” Webman argued. “I want somebody who’s taking a really careful look at it,” he said. “There’s a lot more value to be added by someone who’ll go and do the research in less-understood and less-invested markets.”

To put it another way, it’s hard to learn anything new about an S&P 500 company. Those are the 500 biggest U.S. companies — everyone has heard of them and thousands of analysts scrutinize them all day long.

But who’s keeping an eye on, say, the Peruvian stock market? One manager who takes the time to understand Peru and how to read annual reports from its companies might be able to make a ton of money from insights that would be totally lost on a U.S. stock analyst.

This argument seems intuitively correct. However, I remembered the same argument being made about investing in small companies (aka: “small-caps”) in the United States: the market was less efficient, there was less public information about the companies and the stocks traded less heavily, which meant more opportunities for active managers to make money.

But it didn’t actually work out that way. As Standard & Poor’s put it, “over the last decade, SPIVA has consistently shown that indexing works as well for U.S. small-caps as it does for U.S. large-caps.” SPIVA is Standard & Poor’s Indices vs Active Funds scorecard, which twice a year compares the performance of passive index funds with actively managed funds.

More on that in a moment…

Webman said there are important differences between U.S. small-caps and emerging market companies: In the US, “you do have financial reporting that’s well-established. You have good protection for minority shareholders and you have all of the things that you might not have in an emerging market company.”

I wondered whether SPIVA could help answer this question: in emerging markets, is it better to own a dumb passive index fund that buys all the companies it can, good and bad, or to turn your money over to an expert manager who carefully researches and selects the best companies from each country?

The answer

Well, it’s not even close. Over the five-year period ending in December 2011, only 17% of actively managed emerging markets funds outperformed their benchmark index. Since an index fund hugs the benchmark index as closely as possible, buying the index fund would have put you near the top of the heap. This is typical: it’s difficult to find any five-year period in any investment category where the index fund didn’t trounce most of the competition.

Webman is skeptical of this kind of raw statistical analysis. “I worry about looking at averages,” he said. “It turns out a lot of so-called active managers aren’t so active. And it does look like results are better for active managers who really actively manage their portfolios.” He added that just looking at the number of funds that outperformed doesn’t tell you how much money outperformed. Maybe those few winning funds are actually the biggest funds, which means the average active investor is doing just fine.

Again, this argument sounds reasonable: who cares if most funds don’t beat the index? As long as I can identify a fund that will, I’m golden.

Unfortunately, there’s no evidence that there’s any way to identify the best performers ahead of time, aside from sheer luck. SPIVA also measures performance persistence and the results are appalling. “Very few funds manage to repeat top-half or top-quartile performance consistently,” says the report, which some consider an understatement. For example, in U.S. small-cap funds, less than 4% of funds stayed in the top category five years in a row. They didn’t look at emerging markets funds, but there’s no reason to expect a different result.

High bias

Let’s stipulate that everyone involved in this conversation is biased. Jerry Webman is an executive at a Wall Street firm that sells actively managed mutual funds, S&P is in the business of selling indexes, and I have my life savings in passively managed index funds and am unlikely to go out dragging the river for convincing evidence that I’m investing like an idiot.

If you think Webman is right and I’m wrong, however, I’d like to hear about it.

And let me give Webman the last word: “I think what makes markets is, we’re all going to look at several different kinds of conflicting evidence and come to different conclusions.” I couldn’t agree more.

Matthew Amster-Burton is a personal finance columnist at Mint.com. Find him on Twitter @Mint_Mamster.