Why think twice about investing in an EM ETF

Brian S. Freiwald, CFA, Portfolio Manager, 03/25/21

Confined to a limited investment universe, many passive EM strategies have a less competitive performance record than you might realize.

In contrast, active management can offer superior performance. We show in a recent paper that active strategies outpace passive in emerging markets more often than you might realize.

It’s true that passive investing offers many enticing features for investors. Most strategies focus on specific index benchmarks.

Investors can seek to earn returns close to those of the index, minus expenses. This formula works in many cases. Passive strategies have outperformed a majority of active managers in many investment categories.

The formula does not work so well in the emerging markets (EM) category.

A closer look at performance reveals that low-fee active managers have largely outperformed passive strategies in EM.

active management performance

Active managers can choose better investments

Passive strategies tracking an EM index are limited to a narrower investment universe than active management strategies. (An investment universe is the range of securities in which a portfolio can invest, as defined by its prospectus). Index providers have not necessarily selected stocks with the most attractive return potential.

Active managers have the flexibility to invest in a wider opportunity set, both within and outside the index. In selecting stocks, attractive return potential matters to an active manager.

Our analysis indicates that the investable EM universe is almost 100% larger than the MSCI EM Index that is the basis for many ETFs.

We believe a larger investment universe generally gives active managers advantages. They can cast a wider net, and balance out the variety of opportunities in emerging markets.

An inefficient sector

In general, we believe EM are both more dynamic and under-researched compared with developed markets, providing opportunities for managers who can do cost-effective research to outperform indexes.

EM equity is one of the least efficient sectors of the market and low-cost active managers have generated superior performance relative to their passive counterparts.

Explore more research

A deeper look into cost reveals that actively managed strategies are more competitive than passive strategies in EM. For a more detailed look at our research, read Putnam’s latest paper.

Active vs. passive in emerging markets