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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.
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.
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).
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.
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…
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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.