Passive investing strategies continue to attract big money. But think carefully before choosing to track a benchmark in emerging markets (EM). Active managers offer several clear benefits for equity investors in the developing world.

The flood of money moving into passive strategies shows no sign of letting up. In the first four months of 2017, investors pumped $248.8 billion into passive equity strategies globally while redeeming $58.0 billion from active equity strategies. Low-cost index tracking funds are alluring to investors who have lost faith in active strategies that aim to outperform the market. While some active managers have outperformed consistently, many investors feel that it’s just too difficult to identify them in advance.

Fuzzy Logic

But does this logic hold true in all parts of the global equity market? Not really. In EM, active equity managers have performed especially well. Yet EM funds haven’t been immune to the trend toward passive.

Over the past year, passive global EM equity funds captured $43.0 billion globally, outpacing the $8.7 billion of inflows into active funds. EM is one of the few equity categories that have recorded positive flows to active. Still, passive strategies now account for 32% of total EM equity assets globally, according to Morningstar fund data.

Consistent Outperformance

The concerns about active managers don’t really apply to EM. Most active EM managers have outperformed the index consistently, even after fees. In fact, 70% of active managers in emerging equities have beaten the benchmark over the five-year period ended March 31, 2017, while 66% have outperformed over 10 years, net of fees. On a rolling five-year basis, the percent of active managers outperforming the EM index has never fallen below 50% (Display).

There are several reasons that explain why active managers have a clear advantage in EM, in our view.

Three Active Advantages

First, the EM benchmark simply doesn’t offer the best way to invest in the structural growth potential and dynamism of emerging countries. The index is laden with state-owned enterprises and “old economy” companies. Many of these companies aren’t managed well and aren’t exposed to tomorrow’s growth drivers.

Second, emerging equity markets are also less efficient than their developed counterparts. That means active managers enjoy a greater opportunity to use in-depth research to uncover mispriced securities. The average stock in the MSCI Emerging Markets Index is covered by 16 sell-side analysts, with many smaller stocks receiving little or no analyst coverage. In contrast, the average company in the S&P 500 Index is covered by 23 analysts. Divergent legal standards, accounting practices and languages across countries add to the inefficiency.

Third, the EM benchmark is skewed toward countries that are growing slower than the average pace across the developing world. Companies in slower-growth economies like South Korea and Taiwan comprise about 60% of the MSCI EM. Of course, there are attractive opportunities to be found in these countries. But active managers can provide the best exposure to the most promising stocks in an effort to maximize the potential from an EM allocation.

Powerful Return Potential

It’s an exciting time to invest in EM. This year’s strong returns reflect a sharp improvement in the earnings outlook and the macroeconomic environment after several tough years. What’s more, even after the recent rally, emerging equity valuations are still attractive, at a 26% discount to developing-world stocks based on price to forecast earnings.

But don’t be seduced by low fees when considering an allocation to EM. Sometimes, the cheapest option isn’t the best. In our view, the evidence is clearly tilted in favor of active management for investors seeking to tap the powerful return potential in EM equities.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.

MSCI makes no express or implied warranties or representations, and shall have no liability whatsoever with respect to any MSCI data contained herein. The MSCI data may not be further redistributed or used as a basis for other indices or any securities or financial products. This report is not approved, reviewed or produced by MSCI.

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