The division of foreign markets into developed and emerging segments dates back to 1981, when Antoine van Agtmael, an economist at the World Bank, referred to third-world countries as emerging markets. In a 2011 performance study, the Aperio Group looked at 10 years of return data (12/31/2000 to 12/31/2010) from all active emerging markets mutual funds.
On a pretax basis, just 28% of active mutual funds outperformed their respec-tive benchmark (2/3 of the 28% beat their benchmark by ~ 1% per year). Emerg-ing market hedge funds have done slightly better on a pretax basis, risk-adjusted basis. However, given the reality that hedge funds are generally very tax ineffi-cient, the ever-so-slight benefit likely overstates what happens on an after-tax basis.
Of the 21 countries that comprise the MSCI Emerging Markets Index, two may be promoted to developed market status (Korea and Taiwan). These two countries represent significant market cap weightings in the emerging index. As of March 2012, the top five countries were: China (17% of the index), Brazil (15%), South Korea (15%), Taiwan (11%), and South Africa (8%). The top five countries in the EAFE Index were: U.K. (22%), Japan (21%), France (9%), Australia (8%), and Germany (8%).
Emerging Markets Bonds
As a group, emerging markets have debt equal to ~ 1/3 their GDP, half that of the U.S. The average emerging market has a budget deficit of ~ 2% of GDP versus more than 11% for the U.S.
The investment-grade portion of the J.P. Morgan Emerging Market Bond Index has jumped from 2% in 1993 to 58% by November 2011; > 70% of the issuers in the J.P. Morgan Corporate Emerging Markets Bond Index are investment grade.
As of November 2011, the J.P. Morgan Emerging Bond Index was yielding 6.5%, triple the yield of 10-year U.S. Treasuries. From the beginning of 2012 to mid-November 2012, EMB (iShares ETF based on the J.P. Morgan index) had a total return of 10.3% vs. a total return of 4.3% for TLT, an iShares ETF based on the Barclays 20+ Year Treasury.
Active vs. Passive: Should You Index?
Based on the Aperio Group study (2000-2010), it appears that paying for active management for the emerging markets portion of a client’s portfolio is not a good idea; the chances of beating an emerging markets index mutual fund or ETF is unlikely. Moreover, the chances of a bond fund outperforming its benchmark index are even less likely (since expense ratios typically represent a much higher percentage of any given bond fund’s total return). There is certainly a role for active management, but not for every asset category.
