Who says you need active management to successfully navigate the investment intricacies of emerging markets, when two of the top-performing funds in those markets happen to be passive index-based offerings?

“Contrary to the investment claim that you need an actively managed fund in emerging markets, we’ve proven you can have that exposure through an index fund and perform quite well versus active funds,” says Patrick Thillou, vice-president of structured investments and trading at CIBC Global Asset Management in Toronto, and manager of the CIBC Emerging Markets Index Fund.

Indeed, since its inception in September 2000, the CIBC EMI Fund (which emulates the 25-country MSCI Emerging Markets Index) has produced the second-best five-year average annual compound return – 8.5% -- of all 26 funds in the category. Thillou says part of the fund’s success derives from management’s ability to tweak the tracking to accommodate circumstances.

“We have some leeway to manage the tracking,” says Thillou. “For example, we can hold up to 5% cash in case of withdrawals when the markets fall, and it provides a way to be more prudent. We do try to track the index but we don’t hold all the names. We sample, so we have to look at whether we have the right samples. We have to build the right portfolio and choose the right investments to represent the index.

“Also, investing in emerging markets can sometimes be expensive – custodial fees, taxes and broker’s fees can be high – in Indonesia, for example, you have to pay a lot for a separate custodial account – so we look for the most economical way to invest,” Thillou adds. “If we want Brazil, for example, we might buy stocks in Brazil itself, or we might buy ETFs [exchange-traded Funds], or go to New York and buy ADRs [American Depositary Receipts]. Sometimes there’s a cheaper way to get the same exposure.”

The Pro FTSE RAFI Emerging Markets Index Fund is a newer fund, but it has posted top-quartile returns in every time frame since its inception in November 2007. Stuart McKinnon, president and CEO of Pro-Financial Asset Management Inc. in Oakville, Ont., attributes this success to his company’s exclusive Canadian rights for San Francisco-based Research Associates’ FTSE RAFI Emerging Index (which weights the top 350 large, mid and small company stocks from the FTSE Emerging index using four fundamental factors – dividends, cash flow, sales and book value – rather than market capitalization).

“Research has found that capital-weighted indexes like the S&P500, for example, are flawed because they overweight all the overvalued stocks, and underweight the undervalued stocks,” says McKinnon. “The FTSE RAFI [pronounced footsie raffie] is a fundamental index, so it avoids that problem. It’s rule-based, and it’s completely transparent.

“The fundamental method is a better way to measure economic value because it’s based on information from the company’s own financial statements,” McKinnon adds. “It’s a back-to-basics investment approach that strips human emotion out of the equation. A classic example in Canada would be Nortel. At the peak of the high-tech bubble it represented almost 1/3 of the capital weighted index, but less than 9% of the fundamental index.”

An added benefit for investors with either the CIBC or Pro EMI fund is low cost, because managerial involvement is relatively low and because both funds can use lower-costing proxies – derivatives, ETFs or ADRs, for example, rather than buying stocks outright in what may be costly marketplaces. That translates into an MER of 1.27% for the CIBC fund, and as low as 0.65% for the Pro F Class fund.

The bottom line, as a result, is that investors seeking emerging market exposure can stick with that adage about needing active management, but the passive alternatives aren’t bad from a performance perspective either.

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