Can Vanguard's New Emerging-Markets Fund Beat Its Own Index Fund?

If ever there were an investment category that appeared tailor-made for talented fund managers to excel, it’s emerging markets.

The reason is simple: It’s hard digging up information about companies in exotic locales thousands of miles away from our borders. A manager who is smart and diligent can add value by uncovering nuggets that others miss.

Emerging markets seems just the place to topple the efficient-market theory. That theory holds that investors can’t beat the market because stock prices reflect all of the available information about the underlying companies. Few accept the idea that markets are completely efficient, but most observers have come to believe that the market is pretty efficient -- and awfully tough to beat.

From just $107.88 $24.99 for Kiplinger Personal Finance

Become a smarter, better informed investor. Subscribe from just $107.88 $24.99, plus get up to 4 Special Issues

CLICK FOR FREE ISSUE

Sign up for Kiplinger’s Free Newsletters

Profit and prosper with the best of expert advice on investing, taxes, retirement, personal finance and more - straight to your e-mail.

Profit and prosper with the best of expert advice - straight to your e-mail.

Sign up

The hardest place for an active manager to excel should logically be in large U.S. companies. Apple, for instance, has 47 brokerage analysts tracking its every move. What’s the chance of learning something about Apple before that pack? Smaller companies are less researched, and that means energetic investors are more likely to unearth bargains in that segment of the market.

Virtually no part of the market, however, is less understood than emerging-markets stocks. The companies don’t have to comply with the strict disclosure rules of the developed world. Insider ownership is sometimes hidden. Politics within countries -- think Russia or China -- can be mysterious and unpredictable. Corruption is often a problem.

Find me a top-notch firm with a team of first-rate analysts, and I’d bet my last nickel their emerging-markets fund would leave an index fund in the dust.

Then why is it so hard to find a decent actively managed, no-load emerging-markets fund? Over the past ten years through June 30, the top performer is DFA Emerging Markets Value Institutional (DFEVX) -- an index fund that specializes in undervalued stocks and that is available only in a small number of employer-sponsored retirement accounts or to individual investors who employ a DFA-schooled adviser.

Consequently, I frequently fall back on an old favorite, Vanguard Emerging Markets Stock Index (VEIEX), or its exchange-traded twin, Vanguard MSCI Emerging Markets ETF (VWO). Over the past five years through July 8, the mutual fund version returned an annualized 11.3%, ranking in the top 25% among its peers. Expenses are just 0.35% annually; the ETF charges only 0.22%.

In addition to Vanguard’s low expenses, the secret of the fund’s success lies, I think, in its low turnover. When you buy or sell Apple, the spread between bid and asked prices is usually a penny. And the stock is so heavily traded that even if you’re Will Danoff, managing $80 billion at Fidelity Contrafund (whose largest holding is Apple), you can buy or sell without pushing the price much the wrong way.

In emerging markets, spreads are typically much higher. And the cost of getting into or out of a stock can be huge because many don’t trade very frequently, so a fund’s moves to buy or sell shares push the price in the wrong direction.

Moreover, with fewer securities cops on the beat in emerging markets than in developed lands, stock prices are more likely to be subject to manipulation. For example, front-running by brokers -- buying or selling a stock ahead of a big customer, such as a fund -- is more likely to be found in emerging markets than in the U.S.

So it comes down to this: The Vanguard index fund has just 12% turnover. That means that, on average, it holds a stock more than eight years. By contrast, the average emerging-markets fund has 71% turnover, meaning it typically holds a stock for just a little over a year. “Turnover is an issue in actively managed funds,” says Daniel Newhall, head of manager oversight and selection for Vanguard’s portfolio review group.

Vanguard has hired four outside firms to each run an equal slice of Vanguard Emerging Markets Select Stock (VMMSX), which will try to outpoint Vanguard’s own emerging-markets index fund. The firms all have experience in emerging markets and with Vanguard, which outsources management of nearly all of its actively run stock funds. Annual expenses for the active fund, which launched June 27, are just 0.95%. That’s cheap, though it’s hardly dirt-cheap.

One big negative: The fund is available directly from Vanguard, not through outside online brokerages. Vanguard argues that this policy will prevent the new fund from being inundated with assets, which might make it harder to manage. That’s ridiculous. The fund started with zero assets. The time to close funds is when they’re otherwise in danger of becoming too large, not when they’re first launched. I think Vanguard simply wants more captive investors.

Here are descriptions of the companies that will run the new fund:

Wellington Management runs Vanguard Wellington, Health Care and Energy, as well as parts of other funds. It also boasts 50 global industry specialists and an emerging-markets product that hasn’t been available before to individual investors.

London-based M&G Investment Management runs $261 billion, including Vanguard Precious Metals and Mining and a $1 billion portion of Vanguard International Growth Fund.

Oaktree Capital Management, renowned for its expertise in bonds and private equity, has piloted Vanguard’s superb Convertible Securities fund since 1996. A 12-member Oaktree team has run an emerging-markets hedge fund since 1997, and “they have fantastic results,” Newhall says.

Pzena Investment Management has managed an Irish-domiciled Vanguard fund for non-U.S. investors since 2005.

These are solid managers. Plus, the fund should benefit in the early going from a small asset base. Newhall estimates that annual turnover will be roughly 50% -- lower than average, but much higher than Vanguard’s index offering.

Vanguard is pretty good at identifying solid outside managers. This fund has a decent shot at topping Vanguard’s own index fund. But emerging markets have proven to be the undoing of active management before. My money is on the index fund.

Steve Goldberg (bio) is an investment adviser in the Washington, D.C., area.