Students often ask me for career advice. Not a particularly satisfying experience. For one, they are often exceptionally bright and hard-working people, with PhDs from Oxford or Cambridge in chemical engineering, astrophysics, or some other challenging discipline. I wish they would stick to the science and create something meaningful for our civilization instead of trying to generate a few basis points of excess per year.

On the other hand, some students decided early on to pursue careers in finance and studied accordingly. Telling them to build better fertilizer or rockets makes little sense. But professional financial advice is increasingly difficult to provide. Because? Because global capital markets are already highly efficient and every day machines are taking more and more market share from humans. Career prospects for someone with a master’s degree in finance and some basic Excel skills are steadily declining.

Naturally, it depends on the role. Most of the students dream of becoming a fund manager and managing money. Exchange-traded funds (ETFs) have become its main competitors. So if fund manager is the career aspiration, then perhaps focusing on less efficient markets, whether private or equity niches, is the smart career advice.

After all, fund managers should theoretically be able to extract more alpha from such markets. Of course, in the investment world, reality often deviates substantially from theory. So how have fund managers performed in less efficient stock markets?

Alpha generation in US stock markets

To answer that, we first investigated the ability of fund managers to create alpha in US equity markets. S&P’s SPIVA scorecards offer great insight into mutual fund manager performance.

They paint a pretty dismal picture: 82% of US large-cap mutual fund managers failed to beat their benchmark during the 10 years between 2010 and 2020. From 2000 to 2020, a staggering 94% did not. achievement.

Given that the components of the S&P 500 are the most traded and researched stocks in the world, this should perhaps be expected. However, US small-cap fund managers didn’t fare much better: 76% underperformed their benchmark over the past 10 years, despite all the hidden gems.

Most allocators of capital assume that specialized knowledge has value. Real estate stocks (REITs) are somewhat unusual instruments in that they exhibit characteristics of the stock, bond, and real estate industry. Theoretically, these sectors should offer rich alpha opportunities for dedicated fund managers. Unfortunately, even these markets are too efficient in the United States. More than three in four REIT fund managers (76%) failed to beat their benchmarks.

US Equity Mutual Funds: Percentage Underperforming Benchmarks

Chart Showing US Equity Mutual Funds: Percent Underperforming Benchmarks
Sources: S&P SPIVA Scorecards 2020, FactorResearch

Exploitation of less efficient markets

Compared to their US counterparts, emerging markets are less regulated and company data is not always spread equally. Information asymmetries are significantly greater and many markets, including China, are dominated by retail investors. Overall, this should allow sophisticated fund managers to create substantial value for their investors.

But when we compared equity mutual fund managers from developed and emerging markets, both fared poorly. Of developed market fund managers, 74% underperformed their benchmarks in the three years ending in 2020, compared to 73% of emerging market fund managers.

Equity funds have underperformed their benchmark indices over the last three years

Chart showing equity funds that have underperformed their benchmark indices over the past three years
Source: S&P SPIVA Scorecards 2020, FactorResearch

Although investors tend to select mutual funds based on three years of performance data, that’s a relatively short period of time and may not include a full boom-and-bust market cycle. Fund managers may need more time to prove their acumen and should be evaluated over longer time horizons.

Unfortunately, extending the observation period does not improve the outlook. Mutual fund managers in emerging markets performed slightly worse than their counterparts in developed markets. Over the past five years, 84% have underperformed their benchmark indices, compared to 80% of developed market fund managers. And in the last 10 years, 85% underperformed in emerging markets compared to 82% of their peers in developed markets.

Equity Funds Underperforming Their Benchmarks: Developed vs. Emerging Markets

Chart showing equity funds underperforming their benchmarks: Developed vs. Emerging Markets
Sources: S&P SPIVA Scorecards 2020, FactorResearch

Performance Consistency

To be fair, mutual fund managers’ lack of alpha generation is nothing new. Academic research has pointed this out for decades. Capital allocators emphasize that it is a question of identifying the few funds that consistently generate excess returns. This is an interesting point to evaluate in emerging markets. Fund managers should have more opportunities to gain a competitive advantage given greater information asymmetries compared to developed markets.

S&P also provides data on consistency of performance: it paints a truly bleak picture for US equity mutual funds. For example, only 3% of the top 25% of funds in 2016 managed to stay in the top quartile next year. Over a four-year period, less than 1% did. Put another way, there is no consistency in performance.

By contrast, emerging markets show some consistency in performance over the following year. A random distribution would mean that 25% of the funds in the top quartile are able to maintain their position, with a higher percentage of funds making it than in Brazil, Chile and Mexico.

In subsequent years, however, that percentage plummets, showing that almost no fund shows consistent performance. The best performing mutual funds seem to lack a competitive advantage in the stock markets.

Performance Consistency: Percentage of 2016 Top Quartile Funds Remaining in the Top Quartile

Chart Showing Consistency of Performance: Percentage of 2016 Top Quartile Funds Remaining in the Top Quartile
Sources: S&P SPIVA Scorecards 2020, FactorResearch

Emerging Markets Hedge Funds

Most EM mutual fund managers failed to outperform, and the few that did were lucky rather than slick given a lack of consistency. Perhaps being limited to a set of stocks in a benchmark index is simply not conducive to alpha generation.

So what if we look at the performance of emerging market hedge funds that are relatively free of restrictions? General market conditions shouldn’t matter, as these funds can invest in stocks, bonds, and currencies in long and short positions.

But even these highly sophisticated investors have struggled to beat their benchmarks. The HFRX EM Composite Index shared the same performance trends as the MSCI Emerging Markets Index, albeit with reduced volatility. Performance has been essentially zero since 2012, except for an increase in 2020 reflecting the COVID-19 stock rally, indicating beta rather than alpha.

Emerging Markets Hedge Funds vs. Stocks and Bonds

Chart showing emerging market hedge funds against stocks and bonds
Sources: HFRX, FactorResearch

additional thoughts

Emerging markets are less efficient capital markets with greater information asymmetries than developed markets. Microsoft is covered by more than 30 Wall Street research analysts and Amazon by more than 40. No emerging-markets stock is analyzed in a similar way, and most lack institutional research coverage entirely.

So why are emerging market mutual fund managers unable to take advantage?

Mosaic for the Future of Work in Investment Management: 2021 Report

Management fees reduce alpha for sure, but the main reason is that stock picking is just hard, regardless of the market. There may be more alpha opportunities in emerging markets, but there is also more risk. Argentina managed to get away with selling a 100-year bond in 2017, and Mozambique issued bonds to finance its tuna fleet in 2016. Neither country is likely to be able to handle this today. Fortunes change rapidly in emerging markets where stability is less assured, rendering forecasts useless.

What this means is that focusing on the less efficient stock markets is not a particularly strong career move, at least for those looking for fund management. Perhaps the smartest advice is to simply follow the money, which is pouring into private markets like private equity and venture capital. These are complicated asset classes that are difficult to compare and gauge whether the products offer value. Complexity may be an enemy to investors, but it is a friend to asset management.

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All messages are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

Image credit: ©Getty Images/Mats Anda

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Nicholas Rabener

Nicolas Rabener is the CEO of Finominal, which provides quantitative solutions for factor investing. Previously, he founded Jackdaw Capital, a quantitative investment manager focused on market-neutral strategies. Previously, Rabener worked at GIC (Singapore Government Investment Corporation) focused on real estate across all asset classes. He began his career working for Citigroup in investment banking in London and New York. Rabener holds an MBA from HHL Leipzig Graduate School of Management, is a CAIA charter holder and enjoys endurance sports (100km ultramarathon, Mont Blanc, Mount Kilimanjaro).

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