Unveiling the Active Advantage: Why Emerging Market Investors Are Turning to Active ETFs

Historically, emerging markets have been a place where investors could find growth. As these countries begin and embark on their economic journey, rising GDP rates, consumer consumption and industrial production have led to increases in inventories. In fact, emerging markets have managed to generate an exceptional 20-year average annual return of 9.7% through 2021.

But lately, emerging markets haven’t been so hot. And while the average annual return was much higher, losses in recent years have dampened gains.

This is why many investors have turned to active management in emerging markets. Billions of fund flows have now targeted active emerging ETFs rather than passive vehicles in recent weeks, according to Bloomberg data. These investors may be right. It turns out that active management in developing countries can really benefit portfolios.

Fund Flows Tell an Active Story

In recent weeks, investors have once again turned their attention to emerging markets. Lured by deep discounts to their developed counterparts – of at least 43% – investors have poured billions into emerging market funds. In total, emerging market ETFs collected around $28.2 billion in February this year. This represents a 20% increase from January’s already record fund flows. What’s interesting is where they’re putting these assets now.

And it looks like active ETFs are getting the green light.

According to Bloomberg, active funds hold only about 5% of the $350 billion in emerging markets ETF assets. But this small group of active ETFs has now garnered more than 35% of all fund flows over the past year.

The Chinese problem and active management

So why this increase in flows of ETFs active in emerging markets? Well, it could come down to one world: China.

While 23 countries technically fit the definition of “emerging market,” China dominates them all. As the world’s second-largest economy, China has been a driving force for the returns of major emerging indices over the past few decades. For example, the $17 billion iShares MSCI Emerging Markets ETFwhich tracks the MSCI Emerging Markets sector benchmark, has about 30% of its assets in China.

This was not a problem when emerging markets were booming. As China has transformed from an agrarian society to one of the world’s largest manufacturers, gaining access to the World Trade Organization, the MSCI Emerging Markets Index has surged. From 2001 to 2010, the index posted annualized returns of 15.9%. However, since the Great Recession, emerging markets have only gained about 0.9% per year.

Much like Japan before it, China’s economic slowdown and shift from an industrial, export-based economy to one based on domestic consumption have hurt its torrid growth patterns. Meanwhile, political conflicts with China, the WTO, the United States and other countries have also hurt the giant’s growth potential.

For those examining emerging indices, this question poses a major problem.

But this is where active management can have an advantage. An active portfolio does not need to have as high a weighting in China, if at all. And it turns out that might be a good thing.

MEs are often grouped into a single entity. But this really does a disservice to the various nations and regions classified as emerging countries. India is very different from Peru, which is very different from Poland, etc. Each of these nations has differences in economic output, type of economy, demographics and political risks.

This makes developing country markets very highly differentiated. As we have seen in other highly differentiated markets, such as small cap and fixed income, active managers can exploit nuisances, lack of information and illiquidity. This leads to higher yields. Emerging markets are one of the few areas where active management can and consistently does beat its passive peers.

Becoming active in emerging countries

ETFs only enhance this outperformance. Generally speaking, it is more expensive to manage an emerging market fund than many other asset classes. There are currency spreads to consider, market liquidity, on-the-ground research, etc. But thanks to ETFs’ already low-cost structures, fewer earnings are needed to fund fees. This helps many active managers overcome their fee hurdles and deliver additional returns to investors.

At the same time, the ability to pass on taxes through the creation/redemption mechanism has also helped reduce what investors pay to Uncle Sam. Historically, active emerging market funds have high turnover rates.

To this end, it’s easy to see why so many investors have started turning to active ETFs for their exposure to emerging markets. The proof is in the flow of funds.

ETFs active in emerging markets

These ETFs were selected based on their exposure to emerging markets through active management. They are sorted by their total year-to-date return, which ranges from 3.8% to 7.1%. They have expenses between 0.33% and 0.95% and assets under management between $33M and $3.39B. They yield between 0% and 3.8%.

Ticker Name AUM YTD Price Ret (%) Yield Exp Ratio Security Type Actively managed?

Ultimately, emerging markets can win big when it comes to active management, in part because their differences can be exploited to generate additional returns. It appears investors have gotten the message. Fund flows to active emerging markets are accelerating. And that means gains can be made.

Conclusion

Fund flows show that investors need an active touch when it comes to emerging markets. Maybe they’re right. Active ETFs are great for adding developing countries to a portfolio. Additional gains and outperformance can be achieved.

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