Arguments for passive investing in emerging markets are weak, says Ashmore’s Booth

Jerome Booth, head of Research at Ashmore Investment Management, suggests that there is no additional safety for investors in adopting a passive approach to emerging markets

Employing an active manager comes at the price of higher fees than for a passive manager. Is the difference worth it? This is not a new debate. There are those who claim that on average active managers do not beat passive index managers. Yet there are holes in the theory backing this up and, certainly in emerging markets, convincing evidence to the contrary.

Asset Class Gaps and Distortions

The sources of many arguments lie in different (often implicit) starting assumptions – this one is no different. The ‘market portfolio’ is a theoretical portfolio which includes all possible investments, weighted in proportion to size.
Such a portfolio has ‘systematic risk’ (risk affecting the market as a whole) but no non-systematic or ‘specific’ risk.

The existence of the ‘market portfolio’ is assumed for much of modern portfolio theory and the Capital Asset Pricing Model (CAPM). However, it is a fiction, with managers in practice invariably able to find assets not included in the proxies used to represent the ‘market portfolio’. Emerging debt is a case in point. At $11.4 trillion it is 11.7% of global fixed income, as measured in US Dollars. Though this is larger than the US Treasury market some still do not consider it an asset class. Also, only 12% of the emerging market debt universe is represented by the major emerging debt indices, and proxies of the ‘market portfolio’ omit the bulk of the opportunity set.

What determines an asset class? There is no clear process. Rather it is a matter for convention: what has been and is considered an asset class by one’s peers.

This conservative and unscientific process has led to change in the set of accepted asset classes over time but this change has been slower than, and has lagged changes in, the growth in underlying financial markets.

The building blocks for the ‘market portfolio’ proxies are indices, which not only do not exist for some investment opportunities (there is for example no index yet for emerging market local currency denominated corporate debt, despite this being a $4.1 trillion and accessible market) but also leave out many investments in the asset classes which are included. This is in part because indices are designed to be easy to invest in (erroneously called ‘investible’) rather than comprehensive. For those willing to do a bit more work, there are other opportunities outside the indices.

If managers are forced to buy only within an index, the index is cap-weighted, there are no changes in the set of managers in a given period, and no other holders of the assets, then the average performance (before fees and transaction costs) must be the index performance. This might lead one to prefer passive management for those no better than average at selecting managers. However these assumptions do not hold and the argument is false.

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