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Are Small-Caps a Better Emerging Market ETF Option?

tlydon@globaltrend.com (Tom Lydon)

Emerging market stocks and exchange traded funds provide high returns but are known for their high volatility. However, small-cap emerging market equities have shown robust returns, according to a financial research firm.

MSCI found that emerging market small-caps have generated a 14.1% annualized return over the last decade while also providing portfolio diversification in recent years, reports Lewis Braham for Bloomberg.

Emerging market large-caps moved with the S&P 500 Index 84% of the time over the past three years – emerging market small-caps only had a 0.69 correlation to the S&P. Additionally, over the past 17 years, the average emerging market small-cap has been less volatile than the average large-cap. [Emerging Market ETFs: Higher Growth, Better Demographics]

Emerging market small-caps are less sensitive to developed country problems as they are tied to domestic growth.

“If you look at the broad large-cap emerging-markets index, a lot of the stocks in it are exposed to the developed world, which is in crisis or slow-growth mode,” Todd McClone, manager of the William Blair Emerging Markets Small Cap Growth Fund, said in the article. “Small caps are more exposed to domestic consumption.”

“The small- and mid-cap index is more exposed to the domestic economy, so there is a higher weighting of stable consumer sectors,” Ashish Swarup, manager of the new Fidelity Emerging Markets Discovery Fund, said.

McClone calculates that the top 10 companies on the MSCI emerging market small-cap index generate 91% of their revenue from the domestic economies, whereas top 10 emerging market large-caps garner 58% of revenue from their home economies.

However, the greater volatility in large-caps may be due to the higher investor interest. Still, the less liquid small-caps may become vulnerable to a liquidity squeeze during a serious bear market.

“Also, there are a lot of fund flows coming in and going out of large-cap emerging-market stocks from ETFs and mutual funds, which makes them more volatile,” Swarup added.

Emerging markets small-cap ETFs include:

  • WisdomTree Emerging Markets SmallCap Dividend Fund (DGS - News)
  • SPDR S&P Emerging Small Cap ETF (EWX - News)
  • iShares MSCI Emerging Markets Small Cap Index Fund (EEMS - News)
  • First Trust Emerging markets Small Cap AlphaDEX Fund (FEMS - News)

For more information on developing economies, visit our emerging markets category.

Max Chen contributed to this article.