At a recent client meeting, a consultant stated that they favored active strategies in emerging markets even though, in developed markets, they usually recommended a passive approach. They argued that emerging markets were much less efficient than, say, the US market and that it would therefore be “easier” to add value through active management and to outperform passive strategies.
This view is fairly widely held but, despite its popularity, it is nevertheless false. Recall that active management is always a zero sum game before costs. Thus, after costs, the average investor must underperform the market average. This is a fact that is true for all markets at all times and is based on simple arithmetics. As a consequence, for the average investor, active management cannot pay in any market. So, the real question might be: is it easier to exploit existing skills in a less efficient market? As it turns out, there is no clear answer to this question as it depends on the circumstances of every investor. Obviously, the present discussion assumes that some investors are skilled.
To begin, we have to define some terms. First, what do we mean by “inefficient markets”? It is reasonably clear what is meant by efficient markets – the price of a security perfectly reflects all that is known about its value at all times. But markets might be inefficient in any number of wildly different ways. Are they markets in which most investors are slow to understand and act on the implications of newly arriving information thus allowing the nimble minority to exploit their advantage? Are they markets in which there is only a tenuous relation between price and value so that there is no convergence towards a “fair price” ever? Are they markets in which avalanches of information arrive continuously so that it is essentially impossible to extract the few bits that are relevant in any systematic and timely manner? Or are they markets with extremely poor governance in countries where the rule of law does not exist?
Active investors critically depend on prices reflecting value, on average. Otherwise, if prices never reflected value, their superior insights would be worthless. They would agree with Saint Augustine who asked for “chastity, but not just yet”. Active investors need markets to be efficient, but not just right now. Therefore, “permanently” inefficient and/or dysfunctional capital markets make extremely poor candidates for the successful pursuit of active strategies. This is particularly true for foreign investors who are unlikely to understand the “inner workings” of such markets.
Second, what is “skill”? It is presumably the ability of an investor to identify securities whose current price does not fully reflect their value. But most skilled individuals or investment teams are not universal geniuses. Their advantage is typically limited to a fairly narrow range of assets, e.g., somebody may be a great UK small cap investor but not necessarily able to identify promising Australian infrastructure investments. Investment skill generally travels rather badly.
Also, note that, in any market, there will always be many more active investors than skilled active investors. Given that the average active investor must underperform, the majority of investors who think that they are skilled are simply deluding themselves. They are what Fischer Black called “noise traders”; they are the losers who finance the gains of skilled investors.
Thus, we have generally three basic types of investors present in any market: the unskilled ones who are aware of that fact, pursue a passive strategy and believe in market efficiency, the unskilled noise traders who wrongly believe that they are skilled, who should pursue a passive strategy but do not and who do not believe in market efficiency, and finally the truly skilled investors. As mentioned earlier, an investor may be skilled in one market and unskilled in another one. At the same time, in any given market, investors who believe in market efficiency and those who reject it may co-exist and both may be right – given their respective skill level. Thus, the notion of a particular market being more or less efficient actually makes little sense. Views on market efficiency differ across investors because skill levels differ.
Thus, market efficiency as a concept should not be tied to markets but to market participants. A believer in market efficiency simply admits a lack of investment skill. Investors who consider the US market to be efficient in essence state that they cannot identify any exploitable differences between price and value in that market (nor identify any other investor who can). Of course, those investors cannot possibly know if any such deviations exist but, if they were to exist, they are simply unaware of them and therefore they act as if the market inefficiencies were not present. No unskilled investor can know for a fact whether any market is or is not efficient for all participants in that market. Thus, belief in market efficiency is perfectly rational for unskilled investors; their insistence that nobody can have any meaningful skill is not.
Let us finally go back to the original question: is active management more attractive in less efficient markets such as emerging markets? The discussion in the last few paragraphs suggests that the question actually makes little sense. Active investors will consider the market(s) in which they have skill to be the less efficient ones; since it is unlikely that investors will all be skilled in the same markets, they will not agree among themselves on what markets are more or less efficient.
But let us nevertheless consider the specific case of emerging markets. Are they likely to give better rewards for active management? As a group, active investors will achieve worse results in less liquid markets, such as emerging markets, than in more liquid markets. Costs are higher, which means that an even smaller proportion of those trying can hope to win. Costs are likely to be higher in less liquid markets for a variety of reasons: spreads are wider and custody and management fees are also likely to be higher. Thus, in order to add value, active investors would have to be even more skilled in order to overcome the greater cost disadvantage. Clearly, for the average active investor, the results in emerging markets will be even poorer than in the developed world.
But perhaps it is easier for investors to identify successful active managers in emerging markets? Unfortunately, this also cannot be the case. The same unfortunate result that we found for the average active investor also applies to clients searching for active managers: only a minority can hope to be successful. The cruel reality is that the reliable identification of persistently successful active managers is extremely difficult.
There are periods when a large proportion of active managers outperforms the standard emerging markets benchmarks; is that not evidence of superior skill? Unfortunately, it is not. It is simply a consequence of the fact that the standard benchmarks are tilted towards large cap stocks, while the typical active manager tends to have a mid/small cap bias and perhaps also a style bias. Thus, in periods when those biases are well rewarded, active managers as a group tend to look good relative to the (unrepresentative) benchmark. But the question of untangling style bias and skill must wait for another day.
Thus, there is no reason why active management should be easier in emerging markets than in the developed world. Naturally, there are some successful active investors in both areas – not necessarily the same ones – and, for outsiders, they will be very difficult to identify reliably.