Emerging Market Small Caps: Accessing the Benefits with More Diversification

This week's ETF Brief continues the theme of the favourable outlook for emerging market equities, but examines how a small cap strategy can offer enhanced diversification. The MSCI Emerging Markets Small Cap Index has a lower exposure to China and provides more ways to capture the high growth in other leading Asian economies, including India and South Korea.

Emerging market (EM) equities have it all at the moment: better economic growth than domestic markets, the beneficiary of any US dollar weakening, undemanding valuations, and large catch-up potential. EM equities also offer valuable diversification of exposure from US equities. No wonder we have seen large inflows into both EM ETFs and more broadly into EM equities from institutional investors.

While we remain bullish on growth prospects for China, we know there has been disappointment with recent data releases. To capture the benefits of EM equities with less direct Chinese exposure, investors can consider the MSCI Emerging Markets Small Cap Index.

The Case for Emerging Markets

The narrow equity market rally, focused on the US and technology-related stocks, is causing some concern. EM equities can provide portfolio diversification benefits because of their relatively low correlations with US equities. We provided an in-depth explanation on the case for EM investing in a recent article. 

Potential Benefits from EM Equities Include:

• Forecast GDP growth that is both higher and more stable than that for developed markets. The economic prospects for large economies of Southeast Asia, most importantly India, Taiwan and South Korea (which often get neglected in the focus on China), look exciting compared with the US outlook, which is hindered by the weight of high interest rates and the potential dampening impact on activity given regional banking problems.
• Central banks may be closer to the end of the rate-hiking cycle than in developed markets. While many developing countries have suffered high inflation, as in western economies, there is now an expectation that rates will be cut as disinflation is seen.
• The US dollar is overvalued, and we expect weakness over the next few years. The State Street Global Advisors Currency Model shows that emerging country currencies are 10% undervalued against the US dollar (not seen at this level for more than nine years). EM should benefit from dollar weakness, given historical negative sensitivity that is much higher than other regions.
• Valuation metrics are undemanding, with MSCI Emerging Market P/E at more than a 25% discount to MSCI ACWI and higher dividend yield. The discount rating has opened up as EM have underperformed since early in the COVID pandemic, thus offering one opportunity for a return to the mean in a skewed market.

Investors are responding to this brighter outlook for EM. There have been large, consistent ETF inflows. Institutional investors (as measured within the State Street custody business) continue to add money to EM via individual companies and fund exposures versus most other regions. Despite these relative inflows, these investors still have underweight portfolio positions that remain close to extremes.

The biggest variable to sentiment is China. China's pace of economic activity (in trade, retail and investment) has been disappointing since the reopening of the economy from strict COVID lockdown measures. We remain China bulls and believe that the Chinese administration could boost growth with fiscal stimulus or easing monetary policy. High household cash levels are also available for consumption. However, investors wanting less reliance on this may consider investment strategies with less direct exposure.

EM small caps (as measured by the MSCI Emerging Market Small Cap Index) have various potential benefits but, compared with the MSCI Emerging Markets Index, have several compositional differences: 

• Lower exposure to China (Emerging Markets Small Cap 5% versus Emerging Markets 27%, as shown in Figure 1). While we believe in the long-term story for Chinese growth, we recognise that the level of recent activity has been disappointing and there is concern over geopolitical risk, particularly with regard to US relations and how this could escalate in run-up to the 2024 US presidential election.
• Higher exposure to high-growth economies of India (23%), South Korea (23%) and Taiwan (15%). India’s GDP grew by 6.1% in Q1, helped by a surge in investment in areas such as construction. Forecasts for GDP over the next three years are more than 7% p.a. (according to Bloomberg, as of 1 June 2023). India now has the largest population in the world, having overtaken China.
• Lower weight in financials (11%) than MSCI World (15%) and MSCI Emerging Markets (22%). This relative underweight may partly explain why returns from EM small caps are up in recent months, whereas MSCI small cap indices for USA and Europe have fallen since the collapse of Silicon Valley Bank and the related turmoil in US regional banking, 
• Higher weight in industrials (17%). There are a large number of engineering and electronic component manufacturers in the MSCI Emerging Markets Small Cap Index. Exposures such as these are important when playing a cyclical growth story.

Diversified Emerging Market Representation

The MSCI Emerging Markets Small Cap Index has 1,864 constituents. The largest stock, Ecopro*, is a Korean manufacturer of cathode active materials and precursors for secondary batteries, having a weight of just 0.8% of the index. This company has been opening new plants in Europe to service the burgeoning electric vehicle market and the share price has risen more than four times so far in 2023.

While EM and smaller companies are often seen as more risky investment options, the different country and sector exposures offer diversification. Interestingly, even though volatility (in this case as measured by standard deviation during the past three years) is higher for EM in general compared with developed markets, the MSCI Emerging Markets Small Cap Index has been less volatile over this period than the large cap index.