BRIC Funds With Local Managers Don't Outperform.
The emerging markets asset class has grown tremendously over the past few years. Today, it encompasses a large number of different kinds of financial instruments from a wide variety of countries, for which there are a range of investment vehicles dedicated to getting the best this market has to offer.
Many emerging market funds are also extremely specialized and run by skilled professionals with deep local market insight. But does that in-depth specialization, and the knowledge a portfolio manager has of a particular region, country or asset class, necessarily result in a fund with superior performance?
According to a recent study entitled "Emerging Market Active Managers: Skilled or Stubborn?" conducted by Antonio Fasano, professor of financial markets and institutions at the University of Salerno, Italy, and the LUISS Business University in Rome, the answer is no: Specialization and deep local market insight have little bearing upon a fund's performance.
That's because fund managers with a thorough knowledge of a particular slice of the world or of a specific market segment are more often than not conditioned by behavioral biases that cause them to overlook some of the best investments in their niche area. These local market specialists, Fasano said, tend to become overconfident about their particular area, thinking that they know everything they need to know about it. This leads them to ignore key data that a manager of a broader emerging market fund might consider important, and that might help them eschew poor investments and select better ones.
"Let's say by way of example that I am a Russian fund manager living in Moscow and running a Russia-focused fund: I probably have access to information that a foreign fund manager also investing in Russia probably can't access, but I might also have too much confidence in the information I have access to, and think that something that is actually quite vital is not important at all," Fasano said. "You can also think of this in terms of someone who lives in L.A. and drives their car everyday on the same roads and therefore underrates that risk compared to that same person taking a flight every once in a while and feeling discomfort flying."
The same thing happens, he said, when investors evaluate companies. Very often, "a Russian manager dealing with Russian companies may underrate the risks associated with those companies compared to other emerging market fund managers who are managing broader portfolios and don't have such a deep knowledge of the Russian market."
Fasano and his team conducted their study by using a Bloomberg database of emerging market funds focused on the BRIC region and comparing the performance of these funds based on the nationality of their managers. The team found that a local fund in one of the BRIC countries managed by someone located in that region did not necessarily perform better than a broader BRIC-focused fund managed by a fund manager located elsewhere in the world.
The research also showed that many specialized, locally managed BRIC funds tend to be highly concentrated portfolios. Fasano attributes this to a stubbornness borne from the overconfidence bias that comes from "a fund manager overweighting a portfolio with securities in which they have a strong belief and perhaps even an emotional commitment."
The main question for Fasano and his team "was whether the lack of portfolio diversification is the consequence of fund managerial skills, of generating a positive alpha, or if it's because managers tend to overestimate local information and, consequently, their ability to beat the market. We did not find that focused portfolios overperform, so we believe that behavioral biases prevail over a disciplined asset allocation approach."
Fasano is now working on linking corruption indexes with emerging market fund performance. There are numerous indexes that score emerging market companies worldwide for corruption, he said, and while local investors in different countries have the best knowledge of and access to this kind of information, "it would not surprise me to see that they either disregard this information, or don't take it as investors in other countries do, which will impact their performance."
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