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In Emerging Markets, Smaller Can Be Better

In investing, size matters, but as has been widely documented, there are times when smaller stocks outperform large caps and do so by healthy margin. The advantages of the size factor aren't confined to U.S. markets as some emerging markets exchange traded funds are confirming this year.

What Happened

The WisdomTree Emerging Markets SmallCap Dividend Fund (NYSE: DGS) is higher by about 13.4% year to date, outpacing the large-cap MSCI Emerging Markets Index by nearly 400 basis points in the process. DGS's outperformance of large-cap emerging markets benchmark is not a new phenomenon.

The WisdomTree ETF has done plenty of that since coming to market nearly 12 years ago and over the past year, DGS has been just half as bad as large-cap benchmarks.

Why It's Important

When it comes to U.S. stocks, investors typically expect small caps to be more volatile than larger equities. In emerging markets, one would think that theory holds true, but DGS proves adding dividends to the mix can reduce volatility. Over the past three years, annualized volatility for DGS has been 210 basis points below that of the MSCI benchmark.

DGS typically sports a higher yield than the MSCI Emerging Markets Index. DGS currently yields 4.04%, or nearly double the dividend yield on the MSCI index.

“Over the past 10 years, the MSCI Emerging Markets Small Cap Index had an average dividend payout ratio of nearly 45%, eclipsing the broader MSCI Emerging Markets Index by over 10%,” said WisdomTree in a note out Monday. “This suggests that small-cap companies in emerging markets, despite their growth profiles, are inclined to return their profits to investors in the form of dividends.”

DGS's dividend-weighted methodology gives it a value tilt, positioning the fund for a long-awaited rebound in value stocks.

“Additionally, when an index is weighted by a fundamental metric such as dividends, the result is a tilt toward value-oriented equities, which can double as a form of volatility management,” said WisdomTree. “For example, during the market sell-off this past May, WisdomTree’s Index provided nearly 160 basis points (bps) of downside protection versus broad emerging markets.”

What's Next

Another benefit of DGS is reduced exposure to China. At a time when some large-cap emerging markets ETFs are taking their China exposure to over 30%, the world's second-largest economy is just 15.73% of DGS's roster. Taiwan, one of the highest yielding developing markets, is the largest geographic exposure at 27%.

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