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Summary The notion of a “small-cap premium” is deeply established in investors’ consciousness. Many investors include an explicit allocation to U.S. and international small-cap stocks in their portfolios in order to benefit from the implied outperformance of this market segment. Recently there has been a growing interest in whether making a similar allocation to emerging market small-cap stocks can be beneficial. We detail the motivations of EM small cap investors and whether empirical evidence supports those motivations. By Tim Atwill, Ph.D., CFA, Head of Investment Strategy and Mahesh Pritamani, Ph.D., CFA, Senior Researcher An investor in emerging market small-cap stocks typically has three main motivations behind their interest in the asset class: presumed higher return; better diversification with their developed equity allocation; and more “focused” exposure to the emerging markets, in that small-cap companies tend to be more domestically focused in their economic activities. Below, we lay out the empirical evidence which supports these motivations. We show that while the return advantage and “pure exposure” arguments are strongly supported, the diversifcation benefit is relatively modest. HIGHER RETURNS Historically, small capitalization stocks have been seen as having higher potential returns than mid- and large-cap stocks. However, the bulk of the research examining this premium has focused primarily on the U.S. markets, and, to a lesser extent, the international markets. Below, we compare the excess returns of the MSCI® Emerging Markets Small Cap Index to the MSCI Emerging Markets Index to evaluate whether a similar small-cap premium exists in emerging markets. (click to enlarge) Figure 1 shows that in most years, small-cap stocks earn a relative premium to large- and mid-cap stocks. However, as with most matters in investing, there is no such thing as a free lunch, and several years had notable underperformance. Moreover, the oversized small-cap premium in 2009 highlights the timing risk associated with trying to capture the small-cap premium. This is also evident in Figure 2 which shows the annualized small-cap premium on a rolling 3-year basis, where the realized premium ranges from -5.4% to 9.2%. (click to enlarge) These results indicate that although there is evidence of a small-cap premium in the emerging markets, one has to be invested for the long-term in order to earn it. LOWER CORRELATION WITH DEVELOPED ECONOMY EQUITIES Many argue that small-cap companies are more focused on their local economies, and because of this are less connected to the global economy. Accordingly, such small-cap stocks should provide higher diversification benefits within an investor’s portfolio, versus the benefit from buying equities of larger, more globally-focused companies, which are included in more traditional emerging markets equity allocations. To demonstrate the diversification benefits associated with investing in emerging market small-cap stocks, we calculate the correlation of the MSCI World Index (which represents the equities of the developed markets) to the MSCI Emerging Markets Index, as well as the MSCI Emerging Markets Small Cap Index. (click to enlarge) As can be seen, emerging market small-cap stocks have historically shown a modestly lower correlation with the developed markets than large and mid-cap emerging market stocks. That is to say, emerging market small-cap stocks should provide a higher degree of diversification if included in an investor’s portfolio. Moreover, Figure 3 shows that this diversification benefit persists over most time periods. Therefore, a portfolio which includes an allocation to emerging market small cap stocks should expect to achieve some minor benefits from this lower correlation, including lower predicted portfolio volatility versus a similar portfolio which only includes large- and-mid-cap emerging market stocks. A “FOCUSED” EMERGING MARKETS EXPOSURE One of the reasons for investing in emerging markets, in general, is to gain exposure to smaller, less developed economies which have the potential to grow at a faster rate than developed economies. However, given the globalization of the world economy, several emerging market countries now have a small number of companies that are global in nature and known worldwide. A prime example of this is Korea-based Samsung, a truly global company, whose consumer products (such as TVs and smart phones) are bought all over the world and whose profitability is more likely tied to the world economy than the local Korean economy. A portion of the MSCI Emerging Markets Index constituents is in such global companies, under-cutting to some degree this motivation for investing in the emerging markets. By avoiding such companies, an investor in the small-cap segment of the emerging markets has the potential to obtain an exposure more focused on the local emerging market economies. To quantify this, we look at each company within both the MSCI EM Small Cap Index and the MSCI EM Index, and calculate the percentage of revenue which comes from outside its “home” country. We then capitalization-weight these percentages for each index, and present the results below. (click to enlarge) As shown in Figure 4, emerging market small-cap companies do receive much less of their revenue from outside their home economies (approximately one-quarter, versus almost one-third for large/mid-cap stocks). In addition, this focus on local economies remained relatively static over the past decade, while globally, small-cap companies saw growth in foreign revenues. This data suggests that an investor in the small-cap segment of the emerging markets captures a “focused” exposure to the local emerging market economies, because small-cap names are generally more reflective of local economies, and that this focus is more persistent than is observed globally. CONCLUSION Investors currently hear many arguments for investing in emerging market small-cap stocks, and while these arguments appeal to intuition, we have found varying degrees of support for them in the historical data. After exploring the three most common reasons for investing in the emerging market small-cap stocks – earning a small-cap premium, realizing the benefits of increased diversification, and achieving a more focused exposure to the local economies in emerging market countries – we find supporting evidence for all three of these arguments. One can potentially earn a small-cap premium by investing in small-cap stocks, though there is the risk that small-cap stocks will underperform large- and mid-cap stocks over multiple years. Historical evidence also demonstrates that although emerging market small-cap stocks are less correlated with the developed markets, this diversification benefit is relatively modest in size. It also appears that small companies in the emerging markets are more focused on their local markets, and so are potentially well positioned to benefit from the higher expected growth rates in these developing economies. All in all, we find the data encouraging for those investors who are considering a long-term strategic allocation to emerging markets small-cap stocks. Scalper1 News
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