Actively managed funds are still a useful choice
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Employing an active manager over a passive one comes at a price: higher fees. Is the difference worth it?
This is not a new debate. There are those who claim that average active managers do not beat passive managers who track an index. Yet there are holes in this argument and, certainly in emerging markets, convincing evidence to the contrary.
The sources of many arguments lie in different (often implicit) assumptions – this one is no different. The ‘market portfolio’ is a theoretical portfolio that includes all possible investments, weighted in proportion to size. Such a portfolio has ‘systematic risk’ (risk affecting the market as a whole) but no non-systematic or ‘specific’ risk.
The existence of the ‘market portfolio’ is assumed for much of modern portfolio theory and the capital asset pricing model. However, it is not entirely relevant, with managers in practice invariably able to find assets not included in the proxies used to represent the ‘market portfolio’.
Emerging debt is a case in point. At $11.4trn (£7.3trn) it is 11.7 per cent of global fixed income, as measured in dollars. Although this is larger than the US treasury market, some still do not consider it an asset class. Also, only 12 per cent of the emerging market debt universe is represented by the major emerging debt indices, and proxies of the ‘market portfolio’ omit the bulk of the opportunities available to investors.
So what determines an asset class? There is no clear process. Rather it is a matter of convention: what is, and has been, considered an asset class by one’s peers. This conservative and unscientific process has led to change in the set of accepted asset classes over time – but this change has been slower than, and lagged shifts in, the growth in underlying financial markets.
The building blocks for the ‘market portfolio’ proxies are indices, which not only do not exist for some investment opportunities – there is, for example, no index yet for emerging market local currency denominated corporate debt, in spite of this being a $4.1trn market – but also leaves out many investments in the asset classes that are included.
This is, in part, because indices are designed to be easy to invest in (erroneously called ‘investible’) rather than comprehensive. For those willing to do a bit more work, there are other opportunities outside the indices.
If managers are forced to buy only within an index, and there are no changes in the set of managers in a given period, and no other holders of the assets, then the average performance (before fees and transaction costs) must be the index performance.