Emerging markets are inefficient. To many, the logical response to this statement is that active management is needed to capture those inefficiencies. This, in my opinion, is not true. In fact, because emerging markets are also very risky, the question one must ask when allocating assets to these markets is, "Do you really want to add active manager risk to an already risky asset class?"

There are always specific periods when active managers beat the benchmark, but over longer time periods - five, 10 years or more, the median active manager performance and the index are about the same. The average manager is not beating the benchmark. Indexing is a good, low cost way to get exposure and, in fact over the long term beat the average active manager. However, the approach used in emerging markets should be different from that used in developed markets.

There are structural anomalies in emerging markets which provide an opportunity for alternative strategies which capture the efficiencies of indexing, but also try to benefit from these structural characteristics. One approach, which we call a structured-tiered strategy, identifies and measures structural factors which affect returns in emerging markets.

What are some of these factors?
The size of market. South Africa is 200 times the size in market capitalization of Sri Lanka. It takes three weeks to settle trades in Sri Lanka. Therefore, we would not give the same weight to South Africa and Sri Lanka.

The stage of development. This factor captures fundamental shifts and dynamic elements of the emerging markets. Greece, already a member of the European Union, was on track to join the EMU, just as we knew Portugal would. So, on the margin, we gave Greece a higher weight, due to the improving fundamentals that peer pressure provides. Mexico received similar pressure when it joined NAFTA, as do other countries with free trade agreements.

Transaction costs and liquidity. These are crucial factors when investing in emerging markets, as high transaction costs can wipe out potential profits and poor liquidity can make it difficult to achieve the desired allocation. For example, it is over three times more costly to trade in Peru than Taiwan and it can take weeks to buy or sell securities in Sri Lanka and Columbia.

Operational risks. These can be quite significant in emerging markets. Capital controls enacted in Malaysia in 1998 provided unique challenges, and countries such as Pakistan and Zimbabwe also currently have de facto capital controls. Due to investor enthusiasm, Russia was added into the emerging market indices at 5% weighting. Although active managers rushed in, in our strategy we gave Russia a lower weighting than its capitalization weighting because of the high operational risks of the country.

After examining each of these factors, the relative score of each country is determined, assigned factor weights and ranked. The country is then assigned to the appropriate tier. The result is a tiered, index-based strategy. The key element that helps make this strategy work is disciplined and consistent rebalancing, based on sensible criteria. In our case, the rebalancing trigger is activated fairly often, as the inherently volatile emerging markets frequently overshoot and undershoot.

Why This Works
Emerging markets are generally much more volatile than developed markets, as well as less correlated to each other. A lot of discussion has focused on how emerging market correlation has gone up relative to Canada or the U.S. But relative to each other, emerging market correlations are still quite low. Index-based strategies are the most efficient way to capture this lack of correlation.

Active managers get a lot of frequent flier miles and run up a lot of expenses by visiting individual companies, but at the end of the day, as Figure 1 demonstrates, the best stock picker is not going to deliver if they are not in the right country. The light squares assume you are one of the worst stock pickers in the world (in the lowest quartile), but invest in the two best performing markets. The dark squares assume you are one of the best stock pickers in the world (in the highest quartile), but invest in the wrong markets year after year. The figure shows that it is critical to be invested in the right countries. In emerging markets, stock selection doesn't pay.

Steven Schoenfeld is the Head of Emerging Markets Equity Management at Barclays Global Investors in San Francisco.