Index investing still wins in emerging markets

A regular reader sent me the following email: "If you get the chance, I would appreciate you including a piece about whether the Franklin Templeton Developing Markets (TEDMX) fund adds value. Its manager, Mark Mobius, is always quoted as the guru and pioneer of emerging markets investing. Does he do any better than a passive index fund would do over a 5 or 10 year period?"

Before looking specifically at Mobius' record, it's important to note that an argument often made by advocates of active management is that while indexing, or passive investing is the winning strategy in "efficient" markets -- such as the large-cap stocks of developed countries -- active management is the winning strategy in "inefficient markets." And emerging markets are often considered the poster child for inefficient markets.

Returning to Mobius, let's establish his credentials. He is executive chairman of the Templeton Emerging Markets Group and holds a doctoral degree from MIT. He has been involved in emerging markets for more than 40 years and has received numerous industry awards, including Bloomberg Markets Magazine's "50 Most Influential People" in 2011, "Emerging Markets Equity Manager of the Year 2001" by International Money Marketing, and "Ten Top Money Managers of the 20th Century" in a 1999 Carson Group survey. He is clearly both an intelligent and extremely accomplished individual.

But do all these awards make his fund, or other active funds, a better choice than a strategy built around the principles of passive investing?

Using data from Morningstar, we can review returns of TEDMX and compare them to the returns of two passively managed funds, Vanguard's Emerging Markets Index Fund (VEIEX) and the Dimensional Fund Advisors (DFA) Emerging Markets Fund (DFEMX). (Full disclosure: My firm, Buckingham, recommends Dimensional funds in constructing client portfolios.) The following table shows returns for the five-year, 10-year and 15-year periods ending Aug. 18, 2014.

As you can see, TEDMX failed to outperform either of the two passively managed funds in any of the three periods. That performance has earned this "legend" Morningstar's dreaded one-star rating.

Mobius also runs the Templeton Emerging Markets Small Cap Fund (TEMMX). Since the fund hasn't yet been around for 10 years, we'll look at the Morningstar data for the one-year, three-year and five-year periods ending Aug. 18, 2014. For comparison purposes, we'll evaluate its returns against those of the similar DFA Emerging Markets Small Cap Fund (DEMSX).

Here we see that TEMMX outperformed a comparable passively managed fund in the three-year period, but underperformed it in the one- and five-year periods.

Further evidence against active management in emerging markets can be found in Standard & Poor's new European Active Versus Passive Scorecard (pdf). The results for emerging market funds dispel the myth that active management is successful in these "less efficient" markets. For example, 71 percent, 84 percent and 88 percent of actively managed funds underperformed their benchmarks over the one-year, three-year and five-year periods studied, respectively. The average actively managed fund's underperformance was -0.4 percent per year, -1.8 percent per year and -3.5 percent per year over the one-year, three-year and five-year periods, respectively.

William Sharpe demonstrated in his famous paper, "The Arithmetic of Active Management," that passive management does not depend on market efficiency. Instead, it depends on the simple laws of mathematics, or what Vanguard Group founder John Bogle called "The Cost Matters Hypothesis." That hypothesis states: Since all emerging markets stocks must be owned by someone, and passive investors earn the market returns less low costs, and in aggregate, active investors must also earn the market return less high costs, in aggregate passive investors must earn higher net returns than active investors.

The bottom line is that active management is just as much a loser's game in emerging markets as it is in developed markets. It's a game that's possible to win, but the odds of doing so are so poor it's more prudent to not even try.

Correction: This story was updated at 3:30 p.m. ET to correct the table showing one-, three- and five-year returns for TEMMX and DEMSX.