introduction
Students often ask me for profession advice. It’s not a very satisfying experience. On the one hand, these are sometimes exceptionally smart and hard-working individuals with PhDs in chemical engineering, astrophysics or another demanding discipline from Oxford or Cambridge. I wish they’d persist with science and create something useful for our civilization as an alternative of attempting to generate a number of extra base points per 12 months.
On the opposite hand, some students have chosen a profession in finance from an early age and studied accordingly. Telling them to construct higher fertilizers or rocket ships makes little sense. But it’s becoming increasingly difficult to present advice on a profession in finance. Why? Because global capital markets are already highly efficient and machines are taking increasingly market share away from humans each day. The profession prospects for somebody with a master’s degree in finance and a few basic Excel skills are steadily decreasing.
Of course, it relies on the role. Most students dream of becoming fund managers and managing money. Exchange-traded funds (ETFs) have turn out to be their fundamental competitors. So if fund manager is the profession goal, then perhaps specializing in less efficient markets, either private or equity niches, is a great profession move.
In theory, fund managers should have the option to extract more alpha from such markets. Of course, the fact within the investment world often differs significantly from theory. So how have fund managers fared in less efficient equity markets?
Alpha generation within the US stock markets
To answer this query, we first examined fund managers’ ability to generate alpha within the U.S. equity markets. S&P’s SPIVA scorecards provide excellent insights into mutual fund managers’ performance.
They paint a fairly depressing picture: 82% of US large-cap mutual fund managers didn’t outperform their benchmark within the ten years between 2010 and 2020. From 2000 to 2020, an astonishing 94% managed to accomplish that.
This is probably to be expected, on condition that S&P 500 stocks are essentially the most traded and researched stocks on this planet. However, fund managers of U.S. small-cap stocks haven’t fared significantly better: 76% of them have underperformed their benchmark over the past decade, despite all of the hidden gems.
Most investors assume that expertise is invaluable. Real estate equity investments (REITs) are fairly unusual instruments, as they share characteristics of the equity, bond and real estate industries. In theory, such sectors should offer lucrative alpha opportunities for dedicated fund managers. Unfortunately, even these markets within the United States are too efficient. More than three out of 4 REIT fund managers – 76% – didn’t outperform their benchmarks.
US equity funds: Percentage underperformance in comparison with benchmarks
Exploitation of less efficient markets
Compared to the US, emerging markets are less regulated and company data shouldn’t be all the time evenly disseminated. Information asymmetries are much higher and lots of markets, including China, are dominated by retail investors. Overall, this could enable experienced fund managers to create considerable value for his or her investors.
However, when comparing developed and emerging market equity fund managers, each perform poorly. Of developed market fund managers, 74% underperformed their benchmarks over the three years to 2020, in comparison with 73% for emerging market fund managers.
Equity funds have lagged behind their benchmarks over the past three years
Although investors are likely to select mutual funds based on three years of performance data, it is a relatively short time frame and should not encompass the complete boom and bust market cycle. Perhaps fund managers need more time to display their intuition and needs to be evaluated over longer periods.
Unfortunately, extending the commentary period doesn’t improve the angle. The performance of mutual fund managers in emerging markets has been barely worse than that of fund managers in developed markets. Over the past five years, 84% underperformed their benchmarks, compared with 80% of fund managers in developed markets. And over the past ten years, 85% of fund managers in emerging markets underperformed their counterparts in developed markets, compared with 82%.
Equity funds underperform their benchmarks: developed countries vs. emerging markets
Performance consistency
To be fair, the shortage of alpha generation by mutual fund managers is nothing recent. Academic research has pointed to it for many years. Investors stress the importance of identifying the few funds that consistently generate excess returns. This is an interesting point to judge in emerging markets. Given the upper levels of knowledge asymmetries in comparison with developed markets, fund managers must have more opportunities to achieve a competitive advantage.
S&P also provides data on performance consistency: it paints a very bleak picture for US equity funds. In 2016, only 3% of the highest 25% of funds managed to remain in the highest quartile the next 12 months. Over a four-year period, this was lower than 1%. In other words, there is no such thing as a such thing as performance consistency.
In contrast, emerging markets show some consistency in performance over the next 12 months. A random distribution would suggest that 25% of funds in the highest quartile are able to take care of their position, and in Brazil, Chile and Mexico the next percentage of funds have managed to accomplish that.
However, in the next years, this percentage dropped rapidly, showing that nearly no fund has a consistent performance. The best performing mutual funds appear to lack a competitive advantage within the stock markets.
Performance consistency: Percent of 2016 top quartile funds that remain in the highest quartile
Emerging Markets Hedge Funds
Most emerging market fund managers have didn’t outperform, and the few who’ve succeeded have been more all the way down to luck than skill, given the shortage of consistency. Perhaps being restricted to a set of stocks from a benchmark index is solely not conducive to alpha generation.
So how about we evaluate the performance of hedge funds in emerging markets, that are relatively unconstrained? Overall market conditions mustn’t matter, as these funds can take each long and short positions in stocks, bonds and currencies.
But even these highly experienced investors struggled to outperform their benchmarks. The HFRX EM Composite Index has exhibited the identical performance trends because the MSCI Emerging Market Index, albeit with less volatility. Its return has been virtually zero since 2012, apart from a spike in 2020, reflecting the recovery in equity prices after COVID-19 and suggesting beta fairly than alpha.
Emerging Market Hedge Funds vs. Stocks and Bonds
Further considerations
Emerging markets are less efficient capital markets with greater information asymmetries than developed markets. Microsoft is roofed by greater than 30 Wall Street research analysts and Amazon by greater than 40. No EM stock is as closely scrutinized and most lack institutional research coverage.
So why cannot emerging market mutual fund managers reap the benefits of this?
While management fees reduce alpha, the fundamental reason is that stock picking is solely difficult, whatever the market. There could also be more alpha opportunities in emerging markets, but there may be also more risk. Argentina got away with selling a 100-year bond in 2017, and Mozambique issued bonds to finance its tuna fleet in 2016. Neither country could probably try this today. In emerging markets, where stability is less assured, fortunes change quickly, making forecasting pointless.
This signifies that specializing in less efficient stock markets shouldn’t be a very good profession move, at the very least not for those in fund management. The wiser advice could also be to easily follow the cash flowing into private markets reminiscent of private equity and enterprise capital. These are complicated asset classes which might be difficult to check and calculate intrinsic value. Complexity could also be an enemy of investors, but a friend of asset management.
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Photo credit: ©Getty Images / Mats Anda
