Now that passive index strategies are ubiquitous across markets, I am pleased to see that the overall active vs. passive debate is over, replaced by a more nuanced discussion about where each approach makes sense in an investor’s portfolio. I am of the firm belief that emerging markets is an investing space in which active management is not only preferred, but in most cases, vital. Here are my three main reasons why.
Reason #1: Avoiding state-owned businesses
The MSCI Emerging Markets Index (the index) is mostly based on the market capitalization of individual stocks within the index. As a result, it includes a high proportion of telecommunication companies, banks and resource companies.
These companies tend not to provide investors with good returns. This is due to a few key reasons, in my opinion. First, the companies that dominate the index tend to be government-controlled businesses, which means that shareholder returns may not be the top priority for the management teams. They are generally focused on their duty toward their country, rather than to investors. Ultimately, this means our goals may not be aligned with the company’s.
Reason #2: Focus on quality
Second, we believe these types of companies – telecommunications or resource companies, and to a lesser degree, banks – generally don’t have the characteristics of a quality business that we look for.
Our investment discipline focuses on four key elements of a company: strong free cash flows, organic growth rates, returns on invested capital and a sustainable competitive advantage. The companies dominating the market-capitalization weighted EM index may not meet our requirements on these four fronts. Quality-wise, we find them less attractive than other businesses – consumer-related or information technology, for example.
Reason #3: Taking the road less-travelled
Thirdly, investing in companies that are not included in the broad index can actually generate further opportunity to differentiate a portfolio, because unlike in developed markets, many EM companies are not covered by analysts or researched by the investment community. My experience has proven that the less-travelled path provides opportunities.
These are the three main reasons that I believe passive index investing doesn’t provide investors with access to the most attractive investments with comfortable risk/return profiles within the emerging-market space.
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