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Weekly ETF Brief

EM Small-cap Equities: Embracing Opportunities, Avoiding Threats

Emerging market (EM) small caps once again appear to be in the sweet spot, benefitting from resumed political stability in India, signs of a global recovery being led by EMs, and perhaps also CPI moderation in the US.

3 min read
Senior Equity ETF Strategist

Meanwhile, having an underweight to China helps mitigate headwinds stemming from increased trade tensions with the European Union which for the time being is centered around electric vehicle tariffs but is likely to escalate.

Country Composition Is Key

The beauty of the MSCI Emerging Markets Small Cap Index lies in its country composition. An overweight to India coupled with an underweight to China allows the index to benefit from both long-term shifts and also short-term moves. Most recently, the elections in India introduced some volatility as a weaker-than-expected result put Modi’s ability to form a government into question. However, that hurdle appears to have been cleared now and after the initial sell-off in the market, investor optimism has returned. China, on the other hand, enjoyed a short-lived rebound from mid-April to mid-May; but since then, underperformance has resumed. Tensions not only with the US but now also with the European Union are clearly not helping to regain investors’ trust. 

Beyond the two largest EM economies, the MSCI EM Small Cap Index is overweight towards South Korea and Taiwan. Both are high quality emerging markets that remain indispensable parts of the semiconductor and broader electronic equipment supply chain.

World Economy Is Recovering, Not Slowing

Despite tight monetary conditions, global economic activity is rebounding with both manufacturing and services PMIs in the expansion zone. While EM PMIs have been in expansion territory for quite some time, improvement in global activity should benefit emerging economies and businesses as their prosperity is dependent on the global recovery. 

More Direct and Efficient Access to Economic Growth

EM economies continue to outpace the developed world and India is taking the baton as a growth leader. While India is only 20% of the size of the Chinese economy,1 it has the potential to continue closing the gap over the next decade, given supportive secular trends in demographics, foreign investments, and geopolitical stance. Moreover, the percentage of companies flagged as state-owned is only 9% for EM small caps while the corresponding number for large caps is 23%2. This allows the index to significantly reduce exposure to companies that potentially have a less efficient organizational structure.

Long-term Outperformance

The MSCI EM Small Cap Index has outperformed the MSCI Emerging Markets Index over the past years by a wide margin. Factors driving the difference in long-term returns — including country mix and more local exposure — are structural and therefore likely to continue. Despite the rally, valuations are not stretched with the MSCI EM Small Cap Index forward P/E at 13.57x against a forward P/E of 12.02x for the MSCI EM Index3. In our view, the numerous tailwinds supporting EM small caps more than justify that difference.

How to Access EM Small-cap Equities

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