Bumper returns in emerging markets this year have inspired many investors to get a slice of the action. But should you just aim to follow the indices, which are currently doing well, via a passive fund or should you buy into the expertise of an active manager?
Active funds' managers can asset allocate strategically taking conviction plays on geographic areas or the types of companies they think have a higher chance of performing strongly. Funds that track an index such as MSCI Emerging Markets or FTSE Emerging Markets typically hold all or most of the equities that are included in the index based on their market capitalisation, or deliver the return of those indices using derivatives.
Mona Shah, senior collectives analyst at Rathbones, says: "The MSCI Emerging Markets index is dominated by big industrial and banking stocks that are often quasi-government or state-owned enterprises, so if you don't want to be exposed to the banks in emerging markets, and want to have less exposure to cyclicality and commodities, then you should not invest passively."
Active funds with exposure to smaller companies in these markets, particularly those with a consumer focus in areas such as technology and healthcare, are more likely to benefit from potential future growth.
Active funds can also be useful when investing in emerging markets as these are often under-researched, says David Liddell, chief executive of online investment service IpsoFacto Investor. This means their investment teams are able to use local knowledge and their research capabilities to find hidden gems.
Investment trusts in particular can take long-term bets on these as they do not have to sell assets to meet investor redemptions.
But the ability to invest strategically and with conviction can also be a major drawback for active funds if their managers' views are wrong. And as active funds are more expensive than passive funds investors can end up paying more for a poorly performing fund that does not beat the index.
"Active managers have an advantage in emerging markets," says Ms Shah. "But when the market has shorter, sharper rallies that are driven more by cyclical stocks, high-beta stocks or commodity exposures, then a typical active manger will underperform as they're more exposed to the consumer story."
"If you want general emerging markets exposure at low cost and you don't have a particular conviction on which particular parts of the world you want to get exposure to, then an exchange traded fund (ETF) or passive fund is a great way of doing it," adds Mr Liddell. "It's really about having that broad exposure, which means you're not subject to asset allocation decisions going wrong."
Investors are able to buy passive funds or ETFs close to net asset value (NAV), unlike emerging markets investment trusts which can trade on discounts and premiums to NAV.
ETFs also enable investors to gain quick exposure to emerging markets and make tactical plays on particular areas, for example via single country ETFs. "There are many ETFs now available that offer small, mid or large cap focuses, or specific sector focuses such as consumer or technology," says Wei Li, head of investment strategy at iShares. "Investors are no longer taking a broad-brush approach to emerging markets as a whole. They are becoming a bit more selective when investing, and ETFs can help investors slice and dice the market."
Examples of single country emerging markets ETFs include HSBC MSCI Russia Capped UCITS ETF (HRUB) and db x-trackers MSCI Indonesia Index UCITS ETF (XMID).
Smaller companies emerging markets ETFs include iShares MSCI Emerging Markets Small Cap UCITS ETF (SEMS) and WisdomTree Emerging Markets SmallCap Dividend UCITS ETF (DGSE).
And investors can also opt for emerging markets sector specific ETFs such as iShares MSCI Emerging Markets Consumer Growth UCITS ETF (CEMG) and db x-trackers MSCI Emerging Markets Information Technology Index UCITS ETF (XMET)
But investing in passive vehicles can be a complement to active funds. The turnaround in emerging markets that began in February saw investors initially allocate to ETFs.
"As investors became a bit more comfortable around the longevity of that rally, or some of the fundamental drivers in that rally, we then saw inflows into active strategies," explains Ms Li. "So it goes to show that ETFs do offer a very quick way of getting into the market, which allows investors to assess where to allocate, including active strategies."
However, as passive funds track an index of stocks, based on market capitalisation, investors holding these funds are exposed to risks associated with the index's construction and characteristics. For example, the companies that are going to power the future growth in emerging markets economies may not be included in the major benchmark indices.
And you also need to be sure you are content with the amount of exposure to particular countries or sectors in the index weighting. Both MSCI and the FTSE Emerging Market Indices have about a 25 per cent weighting to China; however, this could be set to rise to more than 50 per cent if they decide to include China domestic A shares in the future.
Mr Liddell says: "The inclusion of Chinese A shares will make the index a different beast and there could be scope for investor disappointment because effectively you will be getting a China fund for something that is calling itself an emerging markets fund."
