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Purple diamond rocks

EM small caps: Hidden gems in plain sight?

Liliana Castillo Dearth, Equity Portfolio Manager
Alexandra H. Melhuish, CFA, Investment Specialist
2022-03-31
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The views expressed are those of the authors at the time of writing. Other teams may hold different views and make different investment decisions. The value of your investment may become worth more or less than at the time of original investment. While any third-party data used is considered reliable, its accuracy is not guaranteed.

Four reasons we believe in a strategic allocation to EM small caps

  1. Strong performance potential
  2. Portfolio diversification benefits
  3. Direct exposure to domestic EM growth opportunities
  4. An undercovered, inefficient market = fertile ground for active managers

EMERGING MARKETS (EM) HAVE COME A LONG WAY over the past three decades. As these markets have evolved and matured through the years, the number of EM equity strategies has proliferated in response to growing investor acceptance of and interest in the asset class. Today, many investors — retail and institutional alike — have a dedicated allocation to EM equities, yet most continue to be firmly biased toward the larger end of the market-capitalization spectrum.

In our view, this results in an unfortunate missed opportunity because a well-built portfolio of EM small-cap stocks can be an effective complement to an existing core EM equity allocation. For example, despite the COVID- 19 pandemic, EM small caps outperformed both broad EM equities and global equities in 2020.1 In this paper, we make the case for strategically investing in EM small caps and for employing an actively managed approach to this underutilized asset class.

A primer on EM small caps

Definition: EM small-cap equities are generally defined as stocks of companies domiciled in non-developed countries, with market capitalization ranging from US$500 million to US$5 billion.

The opportunity set: The EM small-cap universe is large and diverse (~3,100 companies)2, offering investors a wealth of potentially compelling opportunities (both within and outside the standard index).

The MSCI EM Small Cap Index at a glance2

  • Launched: 1 June 2007
  • Total market capitalization: US$933,545 million
  • Number of countries: 27
  • Number of companies: 1,692

The case for EM small caps

1. Strong performance potential
EM small-cap equities as a group have historically delivered attractive performance results over various multiyear time frames, including relative to the other EM market-cap segments. As one example, over the last two decades, EM small caps have consistently outperformed their large-cap counterparts on a rolling five-year basis (Figure 1). In our view, this suggests that over the long term, an appropriate representation of EM small caps within a larger EM allocation may help improve the long-term return potential of a diversified portfolio.

 Figure1
em-small-caps-fig1.svg

As noted above, the EM Small Cap Index outperformed both the MSCI EM and MSCI World indices last year, generating a return of 19.7% compared to 18.7% for the MSCI EM Index and 16.5% for the MSCI World Index.1 We believe this outperformance amid the COVID-19 pandemic speaks to the potential resilience of the asset class.

While the return potential may not be news to most investors, many are surprised to learn that the strong return potential of EM small-cap stocks does not necessarily come with excessive volatility. We believe a common misperception surrounding EM small caps is that they are…

To read more, please click the download link below.


1EM small caps are represented by the MSCI EM Small Cap Index. PAST RESULTS ARE NOT NECESSARILY INDICATIVE OF FUTURE RETURNS AND AN INVESTMENT CAN LOSE VALUE. Sources: MSCI, Wellington Management. As of 31 December 2020. | 2Source: MSCI. Data as of 31 January 2021. 

Authored by
Liliana Castillo Dearth
Liliana Castillo Dearth
Equity Portfolio Manager
Singapore
Alexandra Melhuish
Alexandra H. Melhuish, CFA
Investment Specialist
Singapore

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