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.

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?

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.  

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

Finding the best income-yielding assets

With fixed term deposit rates declining and bank hybrids being phased out, what are the best options for investors seeking income? This goes through the choices, and the opportunities and risks involved.

Shares

What history reveals about market corrections and crashes

The S&P 500's recent correction raises concerns about a bear market. History shows corrections are driven by high rates, unemployment, or global shocks, and that there's reason for optimism for nervous investors today. 

Shares

The ASX is full of old, stodgy, low-growth companies

Eight of the ASX's top 10 stocks are more than a hundred years old, while in the US there's just one. It points to our market being filled with low-growth dinosaurs compared to the US where innovation and renewal rule.

Retirement

Time to review the family home's exemption from Age Pension test

Improving housing mobility in Australia is crucial for enhancing both individual well-being and the economy. Potential reforms include ensuring greater rental security and incentivising downsizing among older homeowners.

Superannuation

Death benefits from super don't need to be this complicated

This may surprise you, but a person's super balance does not automatically form part of their estate. A simple change could bring greater certainty to Australians, quicker payouts for families, and lower super fees.

Economy

The RBA deserves kudos for a job well done

Over the past few years, the Reserve Bank of Australia has been subjected to a blizzard of criticism. Yet, despite its flaws, it may just have engineered that rarest of beasts: the fabled soft economic landing.

Investing

Asia deserves a closer look from investors

As part of their global exposure, Australian investors typically allocate most to Developed Markets equities, and a smaller portion to Emerging Markets. This looks at the latter position and whether there might be a better way.

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.