The Added Value Of Fundamental Indexing

Conventional investment wisdom holds that investment managers find it far easier to add value in emerging markets than in the developed world. These markets are less mature, with smaller numbers of sophisticated investors, meaning that inefficiencies are larger and last longer. In theory, this should give active fund managers greater opportunities to outperform their benchmark.

In practice, the evidence that active management does better in emerging markets is not convincing. Around three-quarters of US-domiciled emerging equity mutual funds underperformed a capitalisation-weighted emerging market benchmark over the 15 years to December 2011, after adjusting for survivorship bias, according to analysis by Vanguard. The pattern is similar for funds domiciled in Europe.

This less-than-impressive record doesn’t mean that there is no value to be had in emerging markets. But there’s no reason to think that the same performance issues that hinder active management in general are any smaller in these economies. The career risk of underperforming the market could encourage closet indexing just as easily in emerging markets as in developed ones. Indeed, given the increased volatility of emerging markets, the risk might even be higher.

So, if there are opportunities to exploit, it might be a better bet to use an index-based, non-capitalisation-weighted strategy, such as fundamental indexation, to do so. Lacking some of the behavioural biases that cause active managers to underperform, these indices could be a more reliable way to gain from emerging market inefficiencies.

Impressive Results In Back-Testing

Given that fundamental indexing is a relatively new concept and still far from mainstream even in developed markets, there is a limited track record of actual fund performance to draw upon. However, the back-tested (theoretical) performance of fundamental indexation in emerging markets is certainly eye-catching.

In a 2010 paper, Rob Arnott and Shane Shepherd of Research Affiliates, the promoters of fundamental indexation, showed that the FTSE RAFI Emerging Markets index had outperformed the capitalisation-weighted FTSE Emerging Markets index by a huge nine percentage points per year between 1994 and 2009, without greatly increasing volatility.

This was far in excess of the gains, also based on back-testing, mooted for RAFI’s fundamental indexation approach in other markets: there, the claimed outperformance was typically between two and five percentage points a year.

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