How top active managers add value in international equity markets

I've long believed that the debate over whether one should choose an active or passive approach to investment management is ultimately misguided. Investors can benefit greatly by combining both approaches in the same portfolio; the two can be complementary, if employed selectively and with an awareness of the potential performance differences among active and passive strategies.

That awareness is critical, as historical results have shown that the ability of top active managers to consistently outperform over passive approaches has been more prevalent in certain investment categories than in others. One particularly notable category is international equities, where active managers have an abundance of opportunities to not only stand out from the crowd, but add long-term value. While research has shown that a sizable number of U.S. equity managers have outperformed their funds' benchmarks, the opportunity to beat the market appears to be greater in international equities.

While globalization has gone a long way to level the playing field internationally in terms of market access and information, the investment landscape in many markets remains distinctly different and more challenging than it does in the United States. Here's a look at a few of the ways that skilled international equity managers can turn these challenges into opportunities to add value:

• Access to information: In our domestic market, legions of Wall Street analysts parse seemingly every piece of company news, especially when it comes to the largest stocks. In some international markets, detailed financial metrics may not be readily available for all publicly traded companies, and data and news on non-U.S. companies tend to draw less attention than information in our heavily researched market. As a result, analysts' forecasts of future earnings results have been far less accurate for international stocks than for U.S. equities, creating opportunities for active managers. For example, over the five-year period ended September 30, 2016, the median error in forecasts that analysts made nine months prior to the release of actual earnings results was 15.4% for companies in the MSCI Emerging Markets Index and 12.1% for firms in another common international benchmark, the MSCI EAFE Index. For companies in the S&P 500 Index, a U.S. benchmark, the median error was just 6.0%.1
• The value of research: Often, portfolio managers and the analysts supporting them unearth international equity opportunities through boots-on-the-ground research, traveling overseas to assess economic conditions and interviewing corporate management teams to better evaluate individual stocks.
• Market inefficiency: Skilled managers may be able to find opportunities in the market dislocations that can be caused by liquidity disruptions and obstacles to market access that can make international equity markets less efficient than the U.S. market.
• Currency factors: Some international equity managers add value by actively managing currency risk through hedging techniques that convert the value of shares from the local currencies of overseas markets back to U.S. dollars.

Alongside traditional active management, the growth of strategic beta in recent years has opened new avenues to potentially beat equity benchmarks in international markets as well as in the United States. These strategies use custom-designed indexes weighted in favor of certain equity characteristics, such as value, momentum, or size. Strategic beta offers an alternative to traditional passive approaches for generating inexpensive, diversified equity exposure.

To assess how active approaches and strategic beta have fared in international markets, we examined the performance of these strategies against common benchmarks across seven Morningstar international equity categories for the three-year period ended December 31, 2016. For actively managed funds, we found substantial numbers of strategies that outperformed, based on annualized total returns net of fees, across all seven categories: diversified emerging markets, foreign large blend, foreign large growth, foreign large value, foreign small/mid blend, foreign small/mid growth, and foreign small/mid value. In the largest category, diversified emerging markets, 82 of 170 actively managed strategies outperformed, or 48%; in the second-largest group, foreign large blend, 54 out of 127 strategies outperformed, or 43%.² The large number of outperformers suggests that investors have plenty of top talent to choose from in the big categories that tend to draw the most investment dollars.

As for strategic beta, the top strategic beta exchange-traded fund (ETF) outperformed its group's common benchmark across each of the six categories where there were strategic beta offerings with records of three years or longer. The category with the highest number of benchmark-beating strategic beta ETFs was foreign large blend, with 12 of 31 outperforming.³

These findings support the notion that active managers of international strategies have a broad range of tools to generate alpha, or returns that skew positively relative to a benchmark: successful research and securities selection, deft navigation of market liquidity issues, and the ability to overcome obstacles to market access that can put certain overseas markets off-limits to specific categories of investors.

What's more, the sizable number of benchmark-beating international strategies suggests that selective investors can choose among a large pool of international equity funds that have generated strong relative performance in the recent past, through either traditional active management or strategic beta. Identifying the strategies that have the greatest potential to continue performing strongly requires additional due diligence and robust oversight, but investors could be rewarded for those efforts.

1 Thomson Reuters I/B/E/S Estimates, as of 9/30/16.

2 Many funds use different benchmarks than the MSCI international equity indexes that were used in this study as common benchmarks for funds within their respective categories.

3 One of the seven international equity categories, foreign small/mid growth, did not have a strategic beta ETF with a three-year record.

Universe of fund returns is compared against benchmarks in the following categories: diversified emerging markets (MSCI Emerging Markets Index), foreign large blend (MSCI EAFE Index), foreign large growth (MSCI EAFE Growth Index), foreign large value (MSCI EAFE Value Index), foreign small/mid blend (MSCI EAFE Small Cap Index), foreign small/mid growth (MSCI EAFE Small Cap Growth Index), and foreign small/mid value (MSCI EAFE Small Cap Value Index). The MSCI Emerging Markets Index tracks the performance of publicly traded large- and mid-cap emerging-market stocks. The MSCI Europe, Australasia, and Far East (EAFE) Index tracks the performance of publicly traded large- and mid-cap stocks of companies in those regions. The S&P 500 Index tracks the performance of 500 of the largest publicly traded companies in the United States. It is not possible to invest directly in an index. Past performance does not guarantee future results.