Before your investment’s travel: Vaccines and immunisations

In summary, the paper compares active management and passive approaches including single-factor and various multiple-factor approaches. 

Investing in emerging markets is associated with being expensive because brokerage fees are higher and these markets require more specialist knowledge, so many investors have been happy to pay higher fees to have a professional investor select the best emerging market opportunities. This is active management. Sometimes the returns were good, but often they were not. According to the paper “based on historical performance, many active managers have underperformed.”

The paper cites that, the median active manager, according to Morningstar data, has underperformed MSCI EM in 10 out of 14 calendar years. Dispersion in active returns year on year is also significant with some managers underperforming by up to 20%.

It’s little wonder many people found this a poor bargain and moved to lower-cost passive funds that tracked traditional indices. In these new funds, returns could be considered average - not high, not low, just the market average.

But, when it comes to emerging market equity investing in a passive fund, the widely used benchmark is the MSCI Emerging Markets Index, for ease of reading let’s call it the MSCI EM Index. The MSCI EM Index includes almost 1,500 listed companies and there is no way all of these are attractive from an investment point of view. In addition, information is not as easily available or shared in emerging markets, and this inefficiency should create opportunities for investors to uncover attractive investment opportunities before these are reflected in market prices.

The VanEck paper assesses single-factor approaches that have been successful in developed markets, like the quality and value factors. The paper finds that in emerging markets, the efficacy of single-factor approaches in emerging markets is not as pronounced as they are in developed markets due to two key reasons:

1. The many economic cycles within emerging markets countries. According to the paper, emerging markets countries’ stages in the economic cycle are out of step. It cites an example following COVID-19. India, for example, “delivered a consistent period of positive economic activity (as represented by PMI), excluding a few months. In contrast, economic activity surged in Taiwan, peaking in late 2020, and reverting to contractionary by 2022. On the other hand, developed markets experienced consistent phases of the economic cycle.”
2. The return dispersion between countries. According to the paper, the wide dispersion of returns between countries within the index limits the efficacy of a single-factor approach. The paper uses the example of value, which had up to 37% active exposure to a single country. According to the paper, “This presents challenges because if a factor is overweight a country but performs poorly, while the macro environment may bode well for a factor – the active country exposure diminishes the efficacy.”

Innovations in index design for passive funds also go beyond single-factor approaches. So, the paper also considers MSCI’s multiple-factor approaches. In addition to VanEck’s analysis, the paper also cites MSCI research to determine the most appropriate mix of factors for investors.  -

MSCI found that a Diversified Multi-Factor, which targets four factors (value, low size, momentum, quality) was found to produce the most optimal metrics - the highest historical IR and Sharpe ratio.

The VanEck research found that this multi-factor approach overcomes the limitation of the single-factor approaches. It also found that over the long term investors that have utilised MSCI’s Diversified Multi Factor approach have outperformed. 

Taking a diversified approach across factors could be the ‘immunisation’ your investments need for emerging markets.

The VanEck MSCI Multifactor Emerging Markets Equity ETF (ASX: EMKT) tracks the MSCI Emerging Markets Multi-Factor Select Index (EMKT Index).

According to the white paper, EMKT’s multi-factor methodology “is an all-seasons approach that has historically outperformed the benchmark over the long term. The bottom-up approach and selection of four factors quality, value, momentum and low size were found to be the most optimal for maximizing Sharpe and information ratios.”

Key risks: An investment EMKT carries risks associated with: ASX trading time differences, emerging markets, financial markets generally, individual company management, industry sectors, foreign currency, country or sector concentration, political, regulatory and tax risks, fund operations and tracking an index. See the PDS for details.