Adding Value in Emerging Markets Equities - State Street Global ...

SSgA CAPITAL INSIGHTS THE EXCHANGE 

Part of State Street’s Vision thought leadership series 

Adding Value in 

Emerging Markets Equities 

Emerging markets economies have garnered the attention of 

equity investors in recent years, as intriguing growth possibilities 

relative to developed market economies’, coupled with reason- 

able valuations, have prompted many to contemplate initiating or 

increasing overall equity portfolio exposure to developing coun- 

tries. There are good reasons for both passive and active equity 

strategy investing in emerging markets, with the most appropriate 

strategy selection or combination thereof dependent upon each 

investor’s desired level of active risk and return potential. 

For investors interested in active emerging markets equity 

strategies, there may exist diversification benefits to allocating 

capital across strategies with different investment approaches. 

This paper explores varying approaches to investing in emerging 

markets equity portfolios and compares the recent performance 

of these approaches. 

by 

Scott Conlon, CFA 

Portfolio Manager 

Global Enhanced Equity 

The Challenges of Emerging Markets Equity Trading 

Trading in emerging markets (‘EM’) equities is a bit more chal- 

lenging than buying and selling developed markets (‘DM’) 

stocks, as there exist greater barriers to efficiency. Reinforced 

by a continuously evolving and sophisticated trading infrastruc- 

ture, DM equities generally offer traders relatively tight bid-ask 

spreads, high levels of liquidity and ultimately low transac- 

tion costs. Emerging equity trading markets have also evolved 

through time with improvements in trading technology and 

liquidity, yet still don’t offer the same degree of efficiencies 

enjoyed in developed equity trading markets. As such, wider 

bid-ask spreads, lower liquidity and greater commissions result 

in higher transactions costs for even the most experienced 

EM equity traders. Also, taxation concerns have an impact on 

trading costs, with countries such as China, Taiwan, among 

others, imposing differing levels of taxes to transact in their 

domestic markets. 

Investment managers who have a dedicated and experienced 

emerging markets equity trading capability, particularly those 

with a global presence, are best positioned to mitigate the chal- 

lenges associated with trading in emerging markets. Those 

investment firms with emerging markets equity traders housed 

in regional markets have an advantage, as existing relationships 

with local brokers and markets best enable traders to identify 

local liquidity and execute trades most efficiently. 

Considering Passive or Active Investment Strategies 

Deciding whether to invest in a passive or active emerging 

markets equity strategy, or an appropriate combination of both, 

is a logical place to start when thinking about emerging markets 

investment options. The benefits of passive investment strate- 

gies are clear and enticing: the ability to achieve index exposure, 

low management fees and other cost-efficiencies. 

Emerging markets equity indexes have historically experienced- 

higher constituent turnover than developed market equity 

indexes, which require greater portfolio trading for EM index 

replicating managers. Greater trading activity at higher transac- 

tion costs is likely to have more of a negative impact on returns 

for passive EM equity strategies than passive DM equity strate- 

gies. In addition, to obtain exposure to less liquid segments of 

emerging markets equities, some passive managers may choose 

to employ a sampling approach which can lead to portfolio 

returns that differ from index returns.

SSgA CAPITAL INSIGHTS | EMERGING MARKETS EQUITIES 

Chart 1: Historical Strategy Performance: Active vs. Passive 

Passive Strategies, 

Excess Return (%) 1-year 3-year 5-year 10-year 

Median -0.12 -0.31 -0.17 -0.18 

# Strategies 4 3 3 1 

Active Strategies, 

Excess Return (%) 

5th Percentile 12.04 7.18 7.62 4.99 

25th Percentile 2.44 4.09 2.44 3.21 

Median 0.45 1.10 0.73 1.08 

75th Percentile -3.19 -0.97 -1.17 0.07 

95th Percentile -6.51 -3.92 -3.36 -1.21 

Active Strategies, 

Tracking Error (%) 

5th Percentile 9.68 9.54 10.19 8.26 

25th Percentile 6.21 6.09 5.85 5.22 

Median 4.50 4.44 4.56 4.13 

75th Percentile 3.47 3.56 3.82 3.61 

95th Percentile 2.30 2.55 2.73 2.71 

# Strategies 156 139 108 74 

As of December 31, 2011 

Source: eVestment Alliance, SSgA 

Returns are gross of management fees. 

Past performance is not a guarantee of future results. 

For all of these reasons, replicating emerging markets equity 

index returns is difficult, even for passive investment managers 

with deep experience trading in emerging markets. As high- 

lighted in Chart 1, the median institutional passive EM equity 

strategy has lagged the benchmark gross of management fees 

historically. 1 While not included in this universe of institutional 

passive strategies, emerging markets equity exchange traded 

funds (ETFs), with an emphasis on liquidity, often employ 

greater degrees of sampling which has contributed to even 

deeper levels of underperformance historically. 

These challenges exist not only for passive investment 

managers, but also for active investment managers. Greater inef- 

ficiencies in EM equities relative to DM equities result in more 

challenges for traders, but the less efficient nature of emerging 

markets economies and associated markets offer an opportu- 

nistic landscape for skilled active managers to generate alpha. 

In fact, the ability to persistently generate relatively higher levels 

of alpha is a must for active EM managers, if only to overcome 

the hurdle of the higher cost of trading. As shown in Chart 1, 

the median institutional active EM equity strategy has outper- 

formed the benchmark gross of management fees historically. 2 

In fact, over the past 10 years, approximately 80% of the active 

emerging markets equity universe has outperformed the bench- 

mark (subject to survivorship bias). 

An interesting observation from the past few years is the 

evolving degree of dispersion in active manager success and 

tracking error. The difference in relative returns between the 

5th (best) and 95th (worst) percentile active EM strategies 

over the past three years is over 11.1%, just below the 11.4% 

average rolling three year difference in best and worst active 

EM strategies over the full period. This three year difference has 

declined considerably in recent months, as it reached a relative 

high of over 14% in June 2011. 

The realized tracking error for the median active EM strategy 

over the past three years is near the 4.2% average rolling three- 

year tracking error over the full period, though this risk metric 

has come down considerably since its peak in mid-2009. These 

observations are likely a function of the historically high levels of 

equity market volatility experienced in 2008 and 2009, though 

the growing number of active EM strategies with potentially differ- 

entiated investment processes may also be a contributing factor. 

Active Investing: Quant or Fundamental… or Both? 

Investors seeking an active emerging markets equity strategy 

would appear to have a broad universe of managers to choose 

from. Like any asset allocation decision, selecting multiple equity 

strategies with differing investment approaches is optimal from 

a diversification standpoint, though this endeavor is not always 

attainable if the investment size is small or an investor’s resources 

are constrained. However, consideration of the diversification 

benefits of different active investment approaches is important. 

Broadly speaking, active investment strategies can be cate- 

gorized as quantitative or fundamental, or perhaps some 

combination of the two, in regards to the investment approach. 

In general, a quantitative (‘quant’) investment approach seeks to 

generate alpha via a disciplined, objective investment process, 

which can quickly evaluate large amounts of information 

systematically to identify investment opportunities within a broad 

universe. This type of information often includes bottom-up, 

fundamentally-oriented data to uncover mispriced stocks, and/ 

or may also encompass top-down, macro-oriented data to help 

allocate across countries or sectors. Quantitative investment 

strategies are likely to employ risk constraints to seek to achieve 

a certain level of tracking error. 

2


A fundamental investment approach, while sometimes applying 

quantitative tools to filter its opportunity set, relies on qualitative 

analysis and judgment when constructing a portfolio. Similar 

to quant approaches, fundamental managers will employ some 

combination of bottom-up or top-down analysis to reach action- 

able investment decisions. 

However, the fundamental manager tends to reach investment 

decisions based on deeper analysis of a smaller subset of 

investment opportunities, often leading to more concentrated 

positions at the stock level than the typical quant manager. As 

a result of this greater stock concentration that is driven by high 

conviction in fewer ideas, fundamental strategies often are less 

rigorous about benchmark-relative risk constraints, which tends 

to lead to higher tracking error than quant strategies. 

Chart 2 displays the performance of active emerging markets 

equity strategies, separated by quantitative and fundamentally- 

oriented investment approaches over the past decade. 3 The 

data were derived from the eVestment Alliance database, which 

assigns each strategy’s investment approach as fundamental, 

quantitative or a combination of the two. Since it is not clear 

whether fundamental or quantitative techniques contribute more 

within combined investment approaches, this small category of 

strategies has been removed from this analysis. 

There are some interesting findings in this data set. First, funda- 

mental investment strategies have dominated the number of 

active EM offerings historically, as over the past 10 years there 

were over five times as many fundamental strategies as quant 

strategies offered. However, the number of quant strategies 

seems to have been growing at a more rapid rate in recent 

years, as the multiple of fundamental to quant strategies has 

shrunk to just over three times over the past few years. 

Chart 2: Historical Strategy Performance: Quant vs. Fundamental 

Second, both quant and fundamental strategies have had 

success in generating alpha. In fact, the median quant and 

fundamental EM strategies have outperformed the index in all 

historical time horizons, gross of management fees. Further, the 

median quant strategy has outperformed the median funda- 

mental strategy at each historical time horizon. 

Third, across all time horizons the dispersion of performance 

has been wider among fundamental strategies than it has been 

among quant strategies. The best performing fundamental 

strategy outperformed the best performing quant strategy 

over the past one and three years while the worst performing 

fundamental strategy delivered poorer returns than the weakest 

performing quant strategy across all time frames. This likely 

is explained by the greater focus on benchmark-relative risk 

management by quant strategies, as noted above. The higher 

realized tracking error by fundamental strategies lends support 

to this hypothesis. 

Finally, the median quant strategy has delivered an information 

ratio (IR) that is more than twice that of fundamental strategies 

over the past ten years, and over the past three years the median 

quant strategy’s IR was nearly six times that of the median 

fundamental strategy. Over the past decade, quant strategies 

look quite attractive from a risk-adjusted performance standpoint. 

Diversification Using Both Quant and Fundamental Approaches 

While both investment approaches show evidence of delivering 

alpha, are there diversification benefits in allocating capital to 

both quant and fundamental EM equity strategies? An obvious 

way to answer this question would be to estimate the expected 

correlation in active returns for each type of strategy. Though 

this forecast correlation estimate is difficult to predict with 

1-Year 3-Year 5-Year 10-Year 

Returns (%) Quant Fundamental Quant Fundamental Quant Fundamental Quant Fundamental 

5th 10.77 12.77 6.92 7.25 7.79 7.69 5.86 4.84 

25th 3.42 2.84 4.74 2.87 3.18 2.14 3.85 2.90 

Median 1.41 0.04 2.76 0.80 1.70 0.54 3.00 1.07 

75th 0.35 -3.69 0.59 -0.96 -0.63 -1.31 0.65 0.13 

95th -3.02 -7.33 -1.08 -4.21 -1.55 -3.37 0.30 -1.11 

Median Tracking Error (%) 4.35 4.61 3.58 4.65 3.79 4.76 3.99 4.13 

Median Information Ratio 0.32 0.01 0.87 0.15 0.47 0.09 0.68 0.27 

# Strategies 28 97 26 86 14 72 9 50 

As of December 31, 2011 


Returns are gross of management fees. Past performance is not a guarantee of future results. 

3


accuracy, evaluating historical correlation patterns may help 

build forecasts. 

Chart 3 plots the rolling 12-month excess return of the 

median quant and fundamental strategies over the past 10 

years. Also illustrated in this chart is the correlation of active 

returns between quant and fundamental strategies over rolling 

12-month periods. Median quant and fundamental strategies 

both delivered positive rolling 12-month relative performance 

over most of this period, with the one shared period of under- 

performance around the late 2008 to early 2009 time frame, a 

period associated with historical high levels of market volatility. 

The correlation of active returns between the quant and funda- 

mental strategies was lowest during the 2004 through 2009 

period, where it was 24%. However, correlation of active returns 

during the first couple years of this period, as well as during the 

last two and a quarter years, was higher at just over 50% and 

60%, respectively. 

Chart 4 offers summary correlation data related to the active 

returns. The correlation of monthly active returns between the 

median quant and fundamental strategies over the past 10 

years is 40%, certainly a noticeably positive number. However, 

the correlation of rolling 12-month active returns between the 

two approaches over the entire period was only 13%, a consid- 

erably lower number. 

Chart 3: Median Excess Returns, Rolling 12-Month Periods 

January 2002–December 2011 

Median Excess Returns (%) Correlation of Excess Returns 

11 

9 

7 

5 

3 

1 

-1 

-3 

Dec 

2001 

2004 2006 2009 Dec 

2011 

-0.4 

— Quant 

— Fundamental 

— Correlation of Quant vs. Fund Median Excess Returns (RHS) 




1.0 

0.8 

0.6 

0.4 

0.2 

0.0 

-0.2 

Chart 4: Correlation of Median EM Returns: Quant vs. Fundamental 

January 2002–December 2011 

% 

Monthly Active Returns Over Full Period 40 

Rolling 12-Month Active Returns 13 




This is an indication that while the relative performance of the 

two strategy offerings may have been materially positively corre- 

lated over the past decade, the correlation between the two 

investment approaches appears to have been quite low over 

shorter time frames within this ten-year period. This would imply 

that there is the potential for diversification benefits by including 

a quantitative and a fundamental strategy within an active 

emerging markets equity portfolio. 

Summary 

Transaction costs in emerging markets equities are consider- 

ably higher than those for developed market equities, creating 

greater hurdles for passive and active emerging markets 

managers that are likely to continue to have a negative impact 

on relative returns. 

Over the most recent decade, the majority of active EM 

managers appears to have had success in generating alpha 

before management fees. Both quantitative and fundamental 

active EM equity strategies, while utilizing differentiated 

approaches to uncover alpha and construct portfolios, have on 

average outperformed the benchmark over the recent history. 

If recent history is a guide for future expectations, investors 

seeking active management in emerging markets equities may 

want to consider allocating across different types of investment 

approaches, as there may be attractive diversification benefits 

during certain periods of a market cycle. 

1 ‘Passive Strategies’ universe created from eVestment Alliance and is subject to survivorship 

bias. Started with eA All EM Equity universe, then filtered for institutional 

strategies with MSCI Emerging Markets Index as ‘Preferred Benchmark’, reporting 

gross of management fees and Passive for ‘Investment Strategy.’ 

2 ‘Active Strategies’ universe created from eVestment Alliance and is subject to 

survivorship bias. Started with eA All EM Equity universe, then filtered for strategies 

with MSCI Emerging Markets Index as ‘Preferred Benchmark’, reporting gross of 

management fees and Active for ‘Investment Strategy.’ 

3 ‘Quant’ and ‘Fundamental’ universes created from eVestment Alliance, and are subject 

to survivorship bias. Started with eA All EM Equity universe, then filtered for strategies 

with MSCI Emerging Markets Index as ‘Preferred Benchmark’, reporting gross of 

management fees and Active for ‘Investment Strategy.’ Next, filtered for strategies with 

either Quantitative or Fundamental as the ‘Primary Investment Approach’. 

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The views expressed in this material are the views of Scott Conlon through the period ended April 30, 2012 and are subject to change based on market and other conditions. The information 

provided does not constitute investment advice and it should not be relied on as such. All material has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. This 

document contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or 

developments may differ materially from those projected. Past performance is not a guarantee of future results. 

Investing in foreign domiciled securities may involve risk of capital loss from unfavorable fluctuation in currency values, withholding taxes, from differences in generally accepted accounting principles 

or from economic or political instability in other nations. 

Investments in emerging or developing markets may be more volatile and less liquid than investing in developed markets and may involve exposur e to economic structures that are generally less 

diverse and mature and to political systems which have less stability than those of more developed countries. 

Investing involves risk including the risk of loss of principal. 

Risk associated with equity investing include stock values which may fluctuate in response to the activities of individual companies and general market and economic conditions. 

Diversification does not ensure a profit or guarantee against loss. 

©2012 STATE STREET CORPORATION ID1111-INST-3130 0512 Exp. Date: 5/31/2013 

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