What Is Active Emerging Premium?
The Active Emerging Premium refers to the observed tendency or potential for actively managed investment funds in emerging markets to generate superior risk-adjusted returns compared to their passively managed counterparts. This concept falls under the broader umbrella of investment strategy and portfolio diversification. Unlike highly efficient developed markets where information is rapidly assimilated into prices, emerging markets are often characterized by lower market efficiency, fragmented information, and less analyst coverage. These factors can create opportunities for skilled active management to identify mispriced securities and deliver returns in excess of a benchmark, known as alpha. The Active Emerging Premium suggests that active fund managers may be better positioned to exploit these inefficiencies.
History and Origin
The discussion around the Active Emerging Premium is rooted in the long-standing debate concerning active versus passive management in various asset classes. Traditionally, developed markets are considered largely efficient, making it challenging for active managers to consistently outperform their benchmarks after fees. However, when the concept of emerging markets gained prominence in the early 1980s, these markets were viewed as ripe for active managers due to their perceived inefficiencies and rapid growth potential8.
Proponents of active management in emerging markets argued that the unique characteristics of these economies—such as less sophisticated financial infrastructure, varying regulatory environments, and a greater number of less-covered companies—presented fertile ground for diligent stock selection and strategic asset allocation. Over time, as emerging markets matured, the debate continued, with studies periodically re-evaluating whether the Active Emerging Premium still held true. Despite some periods where passive strategies proved competitive, many continue to argue that the structural inefficiencies and complexities inherent in emerging markets continue to reward active investors.
#7# Key Takeaways
- The Active Emerging Premium refers to the potential outperformance of actively managed funds over passive funds in emerging markets.
- This premium is often attributed to the relative inefficiency and complexity of emerging market environments.
- Active managers in these markets may leverage specialized research and deep local knowledge to identify mispriced securities.
- The existence and magnitude of the Active Emerging Premium remain a subject of ongoing debate and vary over different time horizons and market conditions.
- Higher transaction costs and index concentration issues in emerging markets can also influence the potential for active outperformance.
Interpreting the Active Emerging Premium
Interpreting the Active Emerging Premium involves understanding the nuances of how active managers operate within emerging markets and the factors that may contribute to their potential outperformance. Unlike developed markets, where vast amounts of information are quickly priced into securities, emerging markets often have fewer analysts covering a broader universe of companies, particularly smaller firms. This can lead to information asymmetries and opportunities for active managers to uncover value that is not immediately reflected in market prices.
The premium suggests that managers with strong research capabilities, robust investment processes, and the flexibility to navigate diverse regional and industry landscapes can potentially deliver superior returns. For investors, recognizing the Active Emerging Premium means considering that a higher expense ratio associated with an actively managed emerging markets fund might be justified if the manager consistently delivers alpha. However, it's crucial to evaluate actual performance, manager expertise, and fund objectives when assessing the potential for an Active Emerging Premium to materialize.
Hypothetical Example
Consider an investor, Sarah, who is evaluating two hypothetical funds focused on emerging markets: Fund A, an actively managed fund, and Fund B, a passively managed exchange-traded fund (ETFs) that tracks a broad emerging market index. Both funds start with an initial investment of $10,000.
Over a five-year period, the broad emerging market index, which Fund B tracks, generates an average annual return of 8%. Fund B, due to its low fees, delivers a net annual return of 7.8%. Meanwhile, Fund A, managed by an experienced team with a strong focus on liquidity and identifying undervalued companies, achieves an average annual return of 10%. After accounting for its higher mutual funds fees, Fund A delivers a net annual return of 9%.
In this scenario, the Active Emerging Premium for Fund A over Fund B is 1.2% per year (9% - 7.8%). This hypothetical example illustrates how the Active Emerging Premium, when realized, can lead to a significant difference in portfolio growth over time for an investor willing to pay for active management expertise.
Practical Applications
The concept of the Active Emerging Premium has several practical applications for investors and asset allocators designing their portfolios.
- Strategic Asset Allocation: Investors with a long-term view and an allocation to emerging markets often debate whether to use active or passive vehicles. The potential for an Active Emerging Premium encourages many to consider active strategies for this asset class, seeking to capture additional returns beyond what passive index tracking might offer.
- 6 Fund Selection: For those opting for active exposure, the Active Emerging Premium highlights the importance of rigorous due diligence in selecting managers. Factors like a manager's track record, investment process, research capabilities, and fee structure become critical in identifying funds that have the potential to deliver this premium. Data from Morningstar, for instance, provides insights into the success rates of active managers in emerging markets against their passive peers.
- 5 Risk Management: Active managers have the flexibility to navigate governance risks, geopolitical shifts, and index concentration, which are prevalent in emerging markets. This proactive risk management can contribute to the Active Emerging Premium by potentially avoiding significant drawdowns or identifying resilient companies in volatile environments.
- 4 Market Inefficiencies: The Active Emerging Premium underscores that some markets are less efficient than others, providing opportunities for professional management to add value. This contrasts with highly efficient markets where consistently beating the market is extremely difficult after costs.
Limitations and Criticisms
While the Active Emerging Premium is often cited as a reason to favor active management in developing economies, it is not without limitations and criticisms.
One major point of contention is whether the premium is consistent or merely an artifact of specific market cycles or survivorship bias. Critics argue that despite the theoretical advantages of active management in less efficient markets, a significant portion of active emerging market funds still fail to outperform their passive counterparts over extended periods, particularly after accounting for fees. For example, data from S&P Dow Jones Indices (SPIVA) reports often show that a majority of active managers across various categories, including emerging markets, underperform their benchmarks over 5, 10, and 15-year periods(htt3ps://www.spglobal.com/spdji/en/research-insights/spiva/).
Another criticism centers on the cost. Actively managed funds typically charge higher expense ratios than passive ETFs. This higher cost creates a hurdle that active managers must overcome before any outperformance can be passed on to investors. Even if a manager generates gross alpha, high fees can erode the net Active Emerging Premium. Morningstar research indicates that while active managers are often pricey in the emerging markets category, passive funds tend to be significantly cheaper.
F2urthermore, the skill of identifying managers capable of consistently delivering the Active Emerging Premium is challenging. Past performance does not guarantee future results, and few managers consistently rank at the top. The high rate of fund closures or mergers in these categories also suggests the difficulty in sustained outperformance.
#1# Active Emerging Premium vs. Alpha
The terms "Active Emerging Premium" and "alpha" are closely related but refer to slightly different concepts.
Active Emerging Premium specifically describes the observed or anticipated outperformance of actively managed investment strategies within the unique context of emerging markets, relative to passive strategies or benchmarks. It implies that the characteristics of these markets (e.g., inefficiencies, less coverage) inherently create more opportunities for active managers to add value. It's a broad market phenomenon or belief.
Alpha, on the other hand, is a precise measure of a fund's or portfolio's performance relative to the return of its benchmark index, after adjusting for risk. It quantifies the excess return generated by an investment manager's skill in security selection, market timing, or asset allocation. Alpha can exist in any market, developed or emerging, and is not specific to emerging markets. The Active Emerging Premium suggests that achieving positive alpha is more probable or consistent in emerging markets compared to highly efficient developed markets. Essentially, the Active Emerging Premium is the expectation or historical observation of positive alpha being consistently generated by active managers in emerging markets.
FAQs
Why might active management outperform in emerging markets?
Active management may outperform in emerging markets due to less efficient markets, which means information is not always fully or immediately reflected in stock prices. This can create opportunities for skilled managers to identify undervalued assets or avoid overvalued ones, leading to an Active Emerging Premium.
Is the Active Emerging Premium guaranteed?
No, the Active Emerging Premium is not guaranteed. While historical data and theoretical arguments suggest a potential for outperformance by active management in emerging markets, this premium is not always realized and can vary significantly over different time periods and market conditions. Many active funds may still underperform their benchmarks after fees.
How do fees impact the Active Emerging Premium?
Fees significantly impact the Active Emerging Premium. Actively managed funds typically have higher expense ratios than passive management funds. A manager must generate enough gross alpha to cover these higher fees and still provide a net positive premium to investors. If the fees are too high, they can erode or eliminate any potential outperformance.
What are the risks of investing in active emerging market funds?
Risks include higher fees potentially eating into returns, the possibility of underperforming the market, and the inherent volatility and geopolitical risks associated with emerging markets themselves. While active managers aim to mitigate some of these risks through stock selection, success is not guaranteed.