Most Emerging-Market Funds Are Lame Ducks

LONDON -- It appears to be an iron law of investing that at least two out of three fund managers are failures. Every time I see figures comparing how many managers have beaten their benchmark, roughly two-thirds come up short.

I noted this phenomenon back in January, when I pointed out that 2011 had been a disastrous year for managers, with 67% undershooting their benchmark. But far from improving, a massive 75% of active fund managers now underperform!

The lame game
Tracker manager Vanguard recently discovered that 74% of U.K. active funds underperformed the FTSE All-Share in the five years to December 2011. Now the same phenomenon has been spotted in emerging-market funds, where three-quarters of managers have underperformed, according to new research from Of the 41 funds it monitors in this sector, 73% "lame duck" funds scored below average on its rating system.

You would think that given their routine underperformance, fund managers would have lower charges, but of course they don't. In fact, they charge up to six times as much as the cheapest trackers.

Actively ridiculous
When I tell fund managers and IFAs that most actively managed funds are specious junk and investors should either buy low-cost trackers or assemble their own portfolio of individual stocks, they don't even blink. They have their answer off pat.

Yes, they say, there are plenty of underperforming funds out there. You just have to find the managers who do outperform the market year after year.

It's a fair argument, if the manager they are talking about is income supremo Neil Woodford at Invesco-Perpetual or one or two others. But in most cases, it is self-serving nonsense.

Smaller but beautiful
Two emerging-market managers do consistently beat the index. I'm pleased to say that one of them is emerging-market specialist First State Investments, because I hold two of its funds, and both have served me well.

Scottish Oriental Smaller Companies (ISE: SST.L) , an investment trust managed by First State, is up 98% over the past three years, compared to just 40% for its benchmark index. First State Greater China Growth is up 47% in three years, against 16% for its index. It is one of the few unit trusts I still own. The other manager is renowned emerging-market specialist Aberdeen Asset Management (ISE: ADN.L) , which has a string of investment trusts targeting Asia, China, Latin America, India, and beyond.

This only serves to confirm our belief that investment trusts are Foolish.

As for the rest...

Wrong side of the trackers
If you're looking to add to your emerging-market exposure, you could always buy a low-cost exchange-traded fund instead, such as iShares MSCI Emerging Markets or Vanguard Emerging Markets, or a country specialist ETF such as the iShares FTSE China 25.

As a rule, I'm wary of buying emerging-market trackers. In countries with weaker corporate governance -- and you have to include the BRICs in this -- they can buy a lot of dodgy operations. I can see the case for hiring a good active manager to sift out the rubbish.

Trackers tend to perform better in established, heavily researched markets such as the U.S. and U.K., where managers struggle to add value.

Emerging profits
Alternatively, you can invest in U.K. blue chips that are set to benefit from future emerging-market growth. This might include drinks company Diageo, luxury goods company Burberry, and household-goods companies such as Unilever and Reckitt Benckiser, which are all targeting the emerging-market consumer.

You might also try emerging-market fund management specialist City of London Investment Group or expanding U.S. behemoths Apple, Starbucks, and Yum! Brands. However, don't dive in with both feet until we know how that Chinese hard landing is playing out.

Regular Fools won't be surprised to hear that three out of four active emerging-market managers aren't doing their job, but it is astonishing nonetheless.

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At the time thisarticle was published Harvey owns Scottish Oriental Smaller Companies, First State Greater China Growth, Diageo, and City of London Investment Group. He doesn't hold any other shares mentioned in this article. The Motley Fool owns shares of City of London Investment Group and Starbucks. The Fool owns shares of Apple.Motley Fool newsletter serviceshave recommended buying shares of Unilever, City of London Investment Group, Starbucks, Apple, and Diageo.Motley Fool newsletter serviceshave recommended writing covered calls on Starbucks.Motley Fool newsletter serviceshave recommended creating a bull call spread position in Apple. The Motley Fool has adisclosure policy. We Fools may not all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. Try any of our Foolish newsletter servicesfree for 30 days.

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