I’m an active academic and long-time finance professor, so I stay on top of the latest academic research in the fields of finance, especially investments. On occasion, I provide short, easy-to-read summaries of recent and relevant academic research, to help you give your clients the best and most cutting-edge investment advice.
Normally, I use this space to summarize recently-conducted research on investing. But I recently came across a very insightful and useful paper published a few years ago that escaped my radar at the time. Does active management pay? Common knowledge is that actively managed portfolios underperform passively managed ones. A couple of months ago, I wrote about a Federal Reserve Board white paper that found that even though active management underperforms passive management on an overall basis, active management actually outperforms passive management during down markets, which is when outperformance matters most to many investors. In this subsequent new paper that I recently discovered, it turns out that active management also works when it comes to international investing. Here’s an excerpt:
“We find net positive payoffs to active management and that this payoff varies across markets… In the EAFE equity markets, we find a net-of-cost active outperformance of 49 bps per year, while in the (presumably) less efficient emerging markets the active outperformance is a substantial 246 pbs per year.”
So, it turns out that active management not only pays during down markets, but it also pays when it comes to international markets.
At this point, you might be wondering about the following: How can active management pay when it comes to international markets, but not when it comes to domestic markets? There are two factors causing this. First, most international equity markets are not as efficient as U.S. equity markets. Therefore, there are more opportunities to obtain outperformance (from mispricing) by investing in international markets. Emerging markets are likely to be less efficient than some of the more developed European, Asian, and Far Eastern (EAFE) markets, and this is why the outperformance to active management is greater in emerging markets than in EAFE markets.
Second, not every institutional investor buys international securities. For example, some institutional investors (such as pension funds) know that some of their clientele will feel nervous about international investing, especially in emerging markets. Therefore, there are not many institutional investors pouring money into emerging markets, which would otherwise drive down returns. In academic-speak, I would say that institutional investors are constrained in their ability to arbitrage, therefore arbitrage opportunities exists for those institutional investors that can invest internationally.
Finally, you might think some of the international outperformance obtained by active managers may have something to do with risk. That is, you might think that active managers are being rewarded for taking on the additional risk of investing in international markets. The study’s authors considered this possibility.
They found that the risk-adjusted alphas of active management ranged from 48 to 115 basis points (bps) per year for EAFE markets and the risk-adjusted alphas of active management ranged from 270 to 379 bps per year for emerging markets. The reason for the range is because the authors used several different approaches to adjust for risk.
So, what’s the overall takeaway? If you have clients who want both downside protection and also some outperformance, then you might consider actively managed domestic portfolios to obtain the downside protection and actively management international portfolios to obtain the outperformance.
By the way, if you are like me and are critical of mutual funds, then you can also consider putting your clients into separately managed accounts (SMAs) that are actively managed. You might think that SMAs are reserved for ultra-wealthy investors, but today’s technology allows financial advisors to offer to their mass affluent clients the opportunity to invest in actively-managed SMAs with small account sizes. So your clients don’t have to be super rich to invest in SMAs.