Factor Investing in Emerging Markets

Is It Worth It?

November 2019. Reading Time: 10 Minutes. Author: Nicolas Rabener.

SUMMARY

  • The trends in factor performance are similar in emerging and developed markets
  • Factor returns were higher in emerging than in developed markets
  • However, higher transaction costs need to be considered carefully

INTRODUCTION

Capital markets of developed countries like the US are highly efficient and mutual fund managers have struggled to generate any alpha, at least after fees. Theoretically, fund management firms could have decreased costs and created more attractive products years ago, but chose not to do so and subsequently were disrupted by the ETF industry.

Given this, most mutual fund managers in developed markets are facing a bleak future as ETFs are consistently capturing market share in investment products. Perhaps less efficient markets like in emerging economies offer more opportunities to generate alpha. Emerging markets tend to feature more retail investors, which are less sophisticated and can potentially be exploited profitably. After all, someone has to pay for lunch.

However, the S&P SPIVA Scorecards for 2018 highlight that more than 80% of mutual funds in emerging markets like Mexico, Brazil, Chile, and South Africa have underperformed their benchmarks. The underperformance is partially explained by high management fees, which means that investors are better served by allocating to emerging market index products than active fund managers.

Investors can alternatively allocate to smart beta strategies, which also offer the opportunity to outperform markets, but have lower fees than mutual funds. However, it is questionable if factor investing generates the same excess returns in emerging as in developed markets.

In this short research note, we will analyse classic factor investing strategies in emerging markets.

METHODOLOGY

We use publicly available data from the Kenneth R. French library and focus on the Value, Size, and Momentum factors. Value is defined by sorting stocks by their price-to-book multiples, Size by market capitalization, and Momentum by the 12-month performance, excluding the most recent month. The portfolios are constructed dollar-neutral, include small cap companies, and exclude transaction costs. Developed markets are comprised of 23 and emerging markets of 2