A Presentational Problem

I can’t argue with the figures you quote, and it’s not my job to defend active managers, many of whom have clearly done a poor job.

However, I don’t feel that actively and passively managed funds can be compared or assessed in the same way. After all, active managers are paid to take bets on the market’s direction and on country, sector and stock weightings. We expect their performance to diverge from the index return.

An index fund or ETF, by contrast, is supposed to track the index, and if it’s failing to do so by the margin that some emerging markets ETFs have trailed by, then there’s a larger problem for the firms running them and for the clients investing in them, as I suggested in my earlier blog – The Limits Of Indexing.

One of the things I found hard to understand in that blog was why the two iShares MSCI Emerging Markets ETFs (US-listed EEM and Europe-listed IEEM) – two funds run by the same firm and tracking the same index – had such divergent performance figures and such a disparity in their numbers of total stock holdings (653 for EEM versus 328 for IEEM).

If you look at the funds’ management policy in another way, via their top ten holdings, you’ll find other significant differences. Apart from Samsung Electronics, which is the largest holding in both funds (though with differing weightings), the rankings of all the remaining top ten stocks are different for each fund. Additionally, EEM has two stocks in its top ten – InfoSys and HDFC Bank – that aren’t even in IEEM’s top ten, which instead includes America Movil and China Life Insurance.

To me that makes these ETFs as actively managed as any portfolio run by a fund manager. In my first job as a fund manager I remember our active UK portfolios taking much smaller bets on single stock weightings against the underlying index than EEM and IEEM are currently doing.

The divergent management policies followed by EEM and IEEM undoubtedly reflect the liquidity constraints that come with emerging market investing. The obligation in many cases to invest in emerging market stocks in “offshore” (ADR or GDR) form also affects the funds’ policy options. And EEM’s huge size, with US$37 billion in AUM, must limit it in a major way.

You suggest that ETF issuers could get round these liquidity constraints – or the possible problems caused by traders anticipating index changes – by switching their benchmark from the MSCI Emerging Markets index to something else. But isn’t that an active management decision of another kind?

To me, ETF managers have a major presentational problem here. Their so-called passive funds are not really passive. And the active bets that they are taking, or are being forced into taking, are both opaque and detrimental to fund performance. The fact that active managers are not doing a good job either misses the point, in my opinion.

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