For at least two decades, stock investors have known that factors such as cheaper valuations and lower volatility bring better returns. Exchange-traded funds seeking to take advantage in a systematic way—so-called smart-beta ETFs—have proliferated in the U.S. and Europe.
Yet the same hasn’t happened in the emerging world. There are good reasons for that, but investors shouldn’t overlook the opportunities.
According to Morningstar data, the number of smart-beta ETFs with more than half of their assets invested in developed countries is 10 times greater than those with a majority invested in emerging ones. The gap in assets is even steeper: While the former had attracted more than $2.5 trillion by the end of June, the latter had only $35 billion.
It isn’t because factors don’t work in emerging markets.
According to 2018 research by the Dutch asset-management firm Robeco, a portfolio favoring value and momentum stocks within the MSCI Emerging Markets Index generated an annualized return of 16.7% from 1988 through 2017, while the broader index returned an average of 11.4%. That five-percentage-points outperformance is even better than that in developed markets.
This isn’t surprising. Some argue that quantitative strategies, which seek to take advantage of human biases, should do better in emerging markets, where knowledge gaps and market inefficiencies are arguably more abundant.
Take Chinese A shares. According to the Shanghai Stock Exchange Factbook of 2018, retail investors contributed 80% of A shares’ trading volume in 2017, but took just 10% of the total profits.
The reason? The majority of those investors are trend followers who “trade far too often between expensive, upward-trending stocks in large companies” and “appear to be pursuing just about the worst behaviors possible,” wrote Ping Zhou, a portfolio manager at Neuberger Berman, in a June research report.
That herd behavior gives quantitative investors plenty of opportunities. As a result, bets on smaller, less-expensive stocks with short-term losses have performed strongly in China over the past decade, even as greater public awareness of such factors has eroded the potential for gains in the U.S., says Zhou.
If factor investing works so well in emerging markets, why are people staying on the sidelines?
The fact that emerging markets in general have lagged behind developed ones in recent years might be one reason. In addition, active managers have performed well in the developing world, giving investors less reason to shift away from bottom-up stock-picking, as they have in the U.S. “There’s just not as strong a catalyst to shed the active strategies,” says Matt Bartolini, head of SPDR Americas Research.
Liquidity can be another concern. In smaller markets such as many in the developing world, shortages of buyers and sellers can leave large gaps between bids and offering prices. Some investors can wait for the spreads to narrow, but factor ETFs, required to rebalance on a certain day a few times a year, don’t have that option. That can hurt their returns.
Most importantly, investors may be worried about accounting fraud and lower data quality in emerging markets. That’s a particular peril for quant strategies that strictly rely on crunching numbers.
Prices can be manipulated by insiders or government interference, rather than following ordinary market patterns, explains Robeco portfolio manager Jan Sytze Mosselaar. The firm manages one of Europe’s largest quant funds for emerging markets and has a team based in Shanghai dedicated to on-the-ground research.
“We exclude a lot of stocks from our investment universe because we do not trust the data,” he says.
Still, since most quant funds have diversified portfolios, problems with individual stocks tend not to have a significant impact on performance. The long-term benefits of factor investing remain. As more investors come to understand factors better, emerging markets will likely be the next battleground for smart-beta strategies.
Write to Evie Liu at email@example.com