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Weekly ETF Brief

EM Small Caps: Embrace Economic Growth with a Lower China Dependency

EM Small Cap Equities outperformed their larger counterparts year to date due a lower China dependency and a more domestic profile. As inflation is abating globally and developing economies’ growth remains solid, we believe that EM small caps are well positioned for the months ahead.

5 min read
Senior Equity ETF Strategist

Unique Performance

The performance of the MSCI EM Small Cap Index this year has been exceptional in a number of dimensions. It is an EM strategy that has outperformed its equivalent in developed world and a small cap strategy that delivered stronger returns than large caps within its region. The MSCI EM Small Cap Index rallied even higher than MSCI World as of 29 November 2023 and, while the developed large cap performance has been driven predominantly by the “magnificent seven” stocks, EM Small Caps have enjoyed a more broad based rally1.

China Underweight is the Key

While the economic growth of developing countries remains broadly intact, investors have been skepical about investing in EM Equties given the numerous challenges emerging in China have weighed on returns. These included the technology crackdown, geopolitical tensions and a slower than expected post-Covid recovery. EM Small Caps offer a solution to these challenges being heavily underweight China which represents only 8% of the index (vs. 30% for the MSCI EM Index). Instead, the Small Cap Index overweights India which accounts for 27% of the index. The country is expected to grow at a rate north of 6% over the next three years, a significantly faster pace than China. In addition, India is likely to enjoy inflows of fresh capital into both private and public markets which should also provide support for its equity market. Taiwan (22% of the index) is a crucial part of the global tech supply chain and Taiwaneese companies tend to demonstrate strong corporate governance compared to other EMs. South Korea (13% of the index) is another example of a “high quality” Emerging Market with a technology heavy network of companies.

EM Small Caps generate bigger part of their revenue domestically which may continue to be a tailwind in the current environment as developing economies are enjoying relatively robust growth compared to most developed economies, with the exception of the US. It is often argued that the strong economic growth of emerging markets does not translate to performance of EM equities. In that context, Small Cap companies offer a more direct exposure to local developing economies and hence may benefit more from local economic expansion.

Disinflation May Unlock Further Potential Within EM Small Caps

Key Emerging Market currencies have depreciated against the US Dollar over the past two years on the back of a hawkish US Federal Reserve and a worsening geopolitical and macroeconomic backdrop2. The US Dollar strengthening has weighed on the performance of equity indices and on underlying economies, as a lion’s share of the MSCI EM Small Cap Index is represented by South East Asia countries which, by and large, are commodity importers. Abating inflation in the US and more globally could well prove to be a tailwind for EM currencies, economies and equities alike over the medium-term.

A Well Diversified Exposure

Investing in Small Caps across Emerging Markets is a high risk/reward play. Risks may come from limited visibility and analysts coverage or poorer governance in specific companies. The MSCI Emerging Markets Small Cap Index with 1,977 constituents is sufficiently broad to allow investors to diversify away some of these risks. The index is not highly concentrated with the top 10 constituents representing only 3.2% of the total exposure, while the corresponding number for the MSCI Emerging Markets Index is 22.9%. Finally, the weight of state owned companies, which may be less efficient from shareholder’s perspective, is much lower in the MSCI EM Small Cap Index as they account for only 8% while for the MSCI Emerging Markets index the share of state owned enterprises is as high as 23%3.

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