Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 334

Why emerging markets are difficult for index funds

The highly variable and diverse nature of the emerging markets equity asset class makes it well-suited to active management. By remaining benchmark-aware without being benchmark-guided, active managers are free to enhance value by investing in attractive regions, industries and individual companies.

The popularity of ETFs in emerging markets equity

Despite the benefits of active management, investments in emerging markets equity often flow by default to Exchange Traded Funds (ETFs) and other passive vehicles. Over the last five years, passive strategies have attracted almost 2.5 times more capital flows than active strategies into US-domiciled funds, as shown in Figure 1.

Figure 1. Five-year cumulative flows to US-listed active and passive emerging market equity

Emerging markets equity ETFs lagging their benchmarks

In the broader capital markets, the rising popularity of ETFs sometimes may reflect an increased focus on fees. However, ETFs for emerging markets equities are far less capable of delivering benchmark returns than ETFs tracking large capitalisation U.S. equities.

As shown in Figure 2 below, the largest US equity ETF (SPY) has managed to track the S&P 500 over the last 10 years. The two lines replicate each other almost exactly.

However, the median emerging market passive ETF has underperformed the MSCI Emerging Markets benchmark. The following example shows the iShares emerging markets ETFs, and the same is true for Vanguard. They have trailed their benchmarks by a substantial margin since their respective inception dates.

Figure 2. iShares MSCI Emerging Markets ETF has lagged its benchmark since inception

Over the last 10 years, iShares MSCI Emerging Markets ETF (EEM) and Vanguard FTSE Emerging Markets ETF (VWO) have finished in the 79th and 58th percentile respectively among all U.S.-listed emerging markets equity funds. (The variance in performance between the two is a function of iShares targeting the MSCI benchmark while Vanguard is based on the FTSE Russell, which excludes Korea.)

Why is this happening?

The sources of physical ETF tracking error

ETFs attempt to track their target indexes by holding all, or a representative sample, of the underlying securities that make up the index. Generally, higher tracking error in physical ETFs tied to the MSCI Emerging Markets index stems from a combination of factors, including:

Transaction pricing: Due to a lack of liquidity in certain securities, the stock price observed in the calculation of the index is not available to a tracking portfolio. Supply-demand dynamics can push the actual price at which a tracking portfolio can transact to buy or sell to a less favourable level.

Optimised sampling: Physical emerging markets ETFs typically use optimised sampling techniques, whereby they hold a basket of securities designed to match the characteristics of the benchmark, but not exactly the same securities, in the same weightings. Optimised sampling is typically employed where the index has fairly illiquid constituents, a large number of index members or where there exist legal and regulatory barriers to owning certain securities. The nature of the sampling technique is imprecise, which can lead to higher tracking error. The same holds true for ETFs aiming to replicate the MSCI World index, which have lagged that index by 19 basis points (0.19%) on average, relative to synthetic, derivative-based counterparts.

Depositary receipts: many physical ETFs tracking the emerging markets index trade American Depositary Receipts (ADRs) or Global Depositary Receipts (GDRs), instead of buying and selling the underlying local securities. Listed on large U.S. or European exchanges, ADRs and GDRs are designed to mirror the ownership of a company’s domestic stock listing. Deviations between these proxies and their local parents contributes to tracking error in ETFs.

Fees: ETFs, like traditional mutual funds, charge management fees that detract from the products’ net asset value and, in many instances, prevent an ETF from matching the performance of the index it tracks. ETFs also incur shareholder transaction costs through brokerage commissions and bid-ask spreads, which are costs that take away from an investor’s actual return even if not captured in an ETF’s reported performance.

Benchmark inefficiencies provide active opportunities

Setting aside the tracking issues confronting emerging markets equity ETFs, we believe the MSCI emerging markets benchmark itself remains inefficient for the following reasons:

  • Weighting by market capitalisation implies a backward-looking bias toward stocks that have performed well in the past
  • Holdings of state-owned enterprises, whose interests are not necessarily aligned with minority shareholders, can lead to unproductive capital allocation decisions
  • Minimal exposure to small capitalisation stocks hampers access to some of the fastest growing companies in emerging markets
  • Lack of a financial viability requirement for entry of indices may detract from performance
  • The MSCI benchmark is also limited to 1,193 constituents, when there are over 10,000 public companies in the broader emerging markets universe.

Active opportunities in emerging markets

By focusing on company profitability and taking a broader view of the emerging markets stock universe, active managers have the potential to positively differentiate their returns relative to passive strategies and their index benchmarks.

Emerging markets equity is a particularly supportive asset class for active management. The ETFs designed to track emerging markets equity indexes are challenged by illiquidity and sampling issues, while the indexes themselves can be inefficient due to the inclusion of less attractive companies and state-run enterprises, for example. Investors should carefully consider their investment options in order to maximise the capital appreciation potential of this growth asset class.

 

Conrad Saldanha is a Senior Portfolio Manager at Neuberger Berman, a sponsor of Firstlinks. This material is provided for information purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. It does not consider the circumstances of any investor.

For more articles and papers by Neuberger Berman, please click here.

 

RELATED ARTICLES

Emerging market equities are ripe with opportunity

Why an active fund should not perform like its benchmark

Best and worst performing equity funds of 2020

banner

Most viewed in recent weeks

16 ASX stocks to buy and hold forever, updated

This time last year, I highlighted 16 ASX stocks that investors could own indefinitely. One year on, I look at whether there should be any changes to the list of stocks as well as which companies are worth buying now. 

UniSuper’s boss flags a potential correction ahead

The CIO of Australia’s fourth largest super fund by assets, John Pearce, suggests the odds favour a flat year for markets, with the possibility of a correction of 10% or more. However, he’ll use any dip as a buying opportunity.

2025-26 super thresholds – key changes and implications

The ABS recently released figures which are used to determine key superannuation rates and thresholds that will apply from 1 July 2025. This outlines the rates and thresholds that are changing and those that aren’t.  

Is Gen X ready for retirement?

With the arrival of the new year, the first members of ‘Generation X’ turned 60, marking the start of the MTV generation’s collective journey towards retirement. Are Gen Xers and our retirement system ready for the transition?

Why the $5.4 trillion wealth transfer is a generational tragedy

The intergenerational wealth transfer, largely driven by a housing boom, exacerbates economic inequality, stifles productivity, and impedes social mobility. Solutions lie in addressing the housing problem, not taxing wealth.

What Warren Buffett isn’t saying speaks volumes

Warren Buffett's annual shareholder letter has been fixture for avid investors for decades. In his latest letter, Buffett is reticent on many key topics, but his actions rather than words are sending clear signals to investors.

Latest Updates

Investing

Designing a life, with money to spare

Are you living your life by default or by design? It strikes me that many people are doing the former and living according to others’ expectations of them, leading to poor choices including with their finances.

Investment strategies

A closer look at defensive assets for turbulent times

After the recent market slump, it's a good time to brush up on the defensive asset classes – what they are, why hold them, and how they can both deliver on your goals and increase the reliability of your desired outcomes.

Financial planning

Are lifetime income streams the answer or just the easy way out?

Lately, there's been a push by Government for lifetime income streams as a solution to retirement income challenges. We run the numbers on these products to see whether they deliver on what they promise.

Shares

Is it time to buy the Big Four banks?

The stellar run of the major ASX banks last year left many investors scratching their heads. After a recent share price pullback, has value emerged in these banks, or is it best to steer clear of them?

Investment strategies

The useful role that subordinated debt can play in your portfolio

If you’re struggling to replace the hybrid exposure in your portfolio, you’re not alone. Subordinated debt is an option, and here is a guide on what it is and how it can fit into your investment mix.

Shares

Europe is back and small caps there offer significant opportunities

Trump’s moves on tariffs, defence, and Ukraine, have awoken European Governments after a decade of lethargy. European small cap manager, Alantra Asset Management, says it could herald a new era for the continent.

Shares

Lessons from the rise and fall of founder-led companies

Founder-led companies often attract investors due to leaders' personal stakes and long-term vision. But founder presence alone does not guarantee success, and the challenge is to identify which ones will succeed in the long term.

Sponsors

Alliances

© 2025 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.