Efficient market hypothesis and emerging markets

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In previous blogs I have spoken about why stock pickers and traders will fail 98%-99% of the time due to:

  • Costs (buy and selling)
  • Unknown unknowns and known unknowns 
  • Efficient market hypothesis (EMH)
  • Tax inefficient due to stock picking.  
  • Even though EMH isn’t perfect due to behavioral finance studies and other factors, it is true that long-term, it isn’t easy to beat the market by research hours.

How about small caps and emerging markets (EM)?

Investment researcher Zenith Investment Partners did a survey.  They looked at the performance of active vs passive funds in emerging markets for the 12 months to September and found that the funds rated by Zenith produced 15.4 per cent, which is over 4% below the MSCI Emerging Markets Index.  

However they still advocate active management because of the market inefficiencies of emerging markets.  According to this view, professional investor participation is lower compared to developed markets so these market inefficiencies allow active managers to outperform.

They aren’t alone.  In the paper “Emerging Market Portfolio Strategies, Investment Performance, Transaction Cost and Liquidity Risk,” Roberto Violi and Enrico Camerini concluded that stock picking investment strategies historically have worked in EM.

How strong is the empirical evidence for this? Spinedices have done some online search and they found the following:  https://us.spindices.com

                                                                Number of active funds that fail beat the indices

Fund1 year 3 years 5 years 
US S&P 63.8%80.56%84.23%
US Small Cap 47.7%88.83%91.17%
Europe 46.59%59.31%73.26%
Mexico 73.91%95.74%92%
Brazil Large Cap 47.42%72.22%90.83%
Brazil Small/mid cap 47.14%81.61%86.90%
India Large Cap 59.38%53%43.40%
India mis-small cap 72.09%80%43.94%
South Africa 95.92%96.27%93.23%

What is interesting about the figures above is that India’s results would seem to indicate that stock picking can be successful in emerging markets, but South Africa’s, Brazil’s and Mexico’s result suggest the opposite.  At the very least the evidence seems mixed. 

Their data illustrates that, for the last 5-10-15 year periods, 78%, 85% and 95%, respectively, of actively managed, publicly available emerging markets (EM) funds underperformed the EM benchmark.

Furthermore, if we extend the graph to 15 years, between 1992-2017, active EM funds underperformed by 2.6 percentage points.

This isn’t to mention that often the greatest cost of active management is taxes and trading costs. 

As Violi and Camerini explain in their paper,  the cost of trading is higher in EM.  Transaction costs in emerging markets are 95% larger relative to all other markets and over double those observed in the US.

Most of this difference is due to the trading costs, where EM costs are tend to be 1.5 times those of developed markets, but explicit costs are also about 70% higher in the EM space.

The authors found that an active management approach in emerging markets might cost as much as 1.7% per year, which is a huge  hurdle to overcome. 

In addition to that, there are further risks with emerging markets. 

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Efficient market hypothesis and emerging markets 3

Emerging markets have outperformed advanced markets in the last 20 years, but are more volatile.  Usually volatility and stability aren’t linked, but in the case of emerging markets, they are higher risk for a number of reasons.

Firstly, there are more economic, political and social risk. A number of emerging markets are dependent on commodities and/or cheap labour, autocratic government and young and driven populations.

As we have seen in Tunisia, Egypt, South Africa, Brazil and countless others places, emerging markets can turn sour quickly.  As per my previously blog, we have also seen China’s market vastly underperform compared to India, despite stronger growth.  

No emerging market has the corporate governance that the US, UK or EU has. For example, if a major firm in Saudi Arabia or China gets into problems with the government for one reason or another, that could spell the end of the company. 

The emerging markets also seem very dependent on certain companies outperforming. The MSCI Emerging Markets Index increased by close to 20% until last September but firms like Alibaba and Tencent pushed up the average, but investing into these firms has risks as well, because of the trade war and their vulnerabilities  to government and regulatory change at home and abroad (the trade war and ZTE is a case in point).

In conclusion I would keep emerging market asset allocation to 5%-10% maximum.  If you do want to stock pick in the emerging markets, keep your costs low.

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