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Four reasons we believe in a strategic allocation to EM small caps
- Strong performance potential
- Portfolio diversification benefits
- Direct exposure to domestic EM growth opportunities
- 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. 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)1, offering investors a wealth of potentially compelling opportunities (both within and outside the standard index).
The MSCI EM Small Cap Index at a glance1
- Launched: 1 June 2007
- Total market capitalization: US$726,490 million
- Number of countries: 26
- Number of companies: 1,653
The case for EM small cap
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.
While that 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 significantly more volatile than larger EM equities.
We acknowledge that there are certain environments in which EM small caps experience heightened volatility relative to larger caps, such as during during more macro-driven markets when investors are…
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