Unveiling the Active Advantage: Why Emerging Market Investors are Turning to Active ETFs

But lately, emerging markets haven’t been so hot. And that average annual return was much higher, while the last few years of losses have crimped gains. 

This is why many investors have turned to active management in emerging markets. According to Bloomberg data, billions of fund flows have now targeted active emerging ETFs rather than passive vehicles in recent weeks. And those investors just may be onto something. It turns out that active management in developing nations can really deliver for portfolios.

In recent weeks, investors have been returning once again to emerging markets. Lured by deep discounts to their developed peers – of at least 43% – investors have poured billions of dollars into emerging market funds. All in all, emerging market ETFs gathered roughly $28.2 billion in February of this year, which was a 20% increase of January’s already-record-setting fund flows. A certain point of interest is where they are now placing those assets. 

And it looks like active ETFs are getting the nod. 

According to Bloomberg, active funds only hold about 5% of the $350 billion in emerging market ETF assets. But this small cadre of active ETFs has garnered more than 35% of all the fund flows over the last year.

Source: Bloomberg

So, why the surge in active emerging market ETF flows? Well, it could be summed up into one word: China. 

While 23 nations technically fit the definition of an “emerging market,” China dominates them all. As the world’s second-largest economy, China has been a guiding force for the returns of the major EM indices over the last few decades. For example, the $17 billion iShares MSCI Emerging Markets ETF, which tracks the sector benchmark MSCI Emerging Markets Index, has about 30% of its assets in China. 

This wasn’t a problem during the emerging market’s go-go days. As China moved from being an agrarian society into one of the world’s largest manufacturers and entered the World Trade Organization, the MSCI Emerging Markets Index surged. From 2001 to 2010, the index posted annualized returns of 15.9%. However, since the Great Recession, emerging markets have only gained about 0.9% annually. 

Just like Japan did before, China’s economic slowdown and move from an export-based industrial economy to a domestic consumption-based one has hurt its torrid growth patterns. Meanwhile, clashing policy points with China and the WTO, U.S. and other nations have also hurt the giant’s growth potential. 

For investors looking to the EM indices, the issue is a major problem. 

But here is also where active management can have the edge. An active portfolio doesn’t have to have such a high weighting in China – or even at all. And it turns out, this may be a good thing. 

EMs often get lumped together as one entity, but that really does a disservice to the numerous nations and regions that are classified as EMs. India is vastly different from Peru which is vastly different from Poland, etc. Each of these nation’s feature differences in economic output, type of economy, demographics, and political risks. 

That makes developing nations very highly differentiated markets. As we’ve seen with other highly differentiated markets – such as small caps and fixed income – active managers can exploit the nuisance, a lack of information, and illiquidity, leading to higher returns. Emerging markets are one of the few areas where active management can – and consistently does – beat their passive peers.

ETFs are only enhancing that outperformance. Generally speaking, it’s more expensive to run an EM fund than many other asset classes. There are currency spreads to consider, market liquidity, boots-on-the-ground research, and more. But thanks to an ETF’s already-low-cost structures, less gains are required to go towards fees. This is helping more active managers beat their fee hurdles and deliver extra returns to investors. 

At the same time, the ability to pass off taxes through the creation/redemption mechanism has helped reduce what investors pay to Uncle Sam. Historically, active emerging market funds have had high turnover rates. 

To that end, it’s easy to see why so many investors have started to turn towards active ETFs for their emerging market exposure. The proof is in the fund flows. 

These ETFs were selected based on their exposure to emerging markets via active management. They are sorted by their YTD total return, which ranges from 3.8% to 7.1%. They have expenses between 0.33% and 0.95% and assets under management between $33M and $3.39B. They are yielding between 0% and 3.8%.

In the end, emerging markets can win big with regards to active management, thanks in part to their differences that can be exploited for extra returns. It seems that investors have gotten the message. Fund flows into active emerging markets are accelerating – and that means gains can be had.

Fund flows are indicating that investors are craving an active touch when it comes to emerging markets. They may be right. Active ETFs are perfect for adding developing nations to a portfolio. Extra gains and outperformance can be had.