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 Southeast 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 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:
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:
Comparison of Country Breakdown of MSCI Emerging Markets and MSCI Emerging Markets Small Cap
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.
*This information should not be considered a recommendation to invest in a particular sector or to buy or sell any security shown. It is not known whether the sectors or securities shown will be profitable in the future
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