Playing The Emerging Markets Through Small Cap ETFs

by on September 15, 2010 | ETFs Mentioned:

Emerging markets ETFs have become tremendously popular in recent years, as investors frustrated by the stagnant growth in the developed world have been lured in by the impressive economic expansion occurring in the developing world. Though there are many options available, the most popular way to play emerging markets is through VWO or EEM; two ETFs linked to the MSCI Emerging Markets Index. That benchmark is a cap-weighted index that consists of the largest publicly-traded companies listed and operating in emerging markets.

The tilt towards large cap stocks is common in international equity ETFs, many of which are linked to cap-weighted indexes. But in recent years investors have become increasingly interested in rounding out emerging markets exposure by investing in small cap stocks of the developing world, an asset class that often maintains a risk/return profile very different from large cap stocks [see also Guide To Small Cap International ETFs].

Although there are numerous exceptions, large cap equities tend to be multi-national firms that generate revenues not only in their home country, but in both developed and emerging markets around the world. Moreover, baskets of large cap stocks tend to feature a disproportionately high weighting towards energy and financial companies, while underweighting consumer and technology sectors. The iShares MSCI Brazil Index Fund (EWZ) is a good example. Over 16% of its assets are dedicated to Petrobras, one of the largest oil firms in the world that whose profitability depends more on global demand for crude than on the health of Brazil’s local economy. With holdings in global companies, many large cap funds are not necessarily effected by local trends in the economies of the country they invest in. Small cap ETFs, on the other hand, present a more “pure play” on the economy that they track [see also Beyond the BRIC: Ten Country-Specific Emerging Markets ETFs].

Just as in the U.S. equity markets, small cap stocks can exhibit considerable volatility. The exposure offered by small cap equities isn’t necessarily superior to that offered by large caps–in many environments small cap equities will lag behind their large cap counterparts–but it certainly is different. As such, it is perhaps more appropriate to think of small cap equity ETFs as complements to large cap funds, rather than substitutes.

There are now a number of ETFs offering exposure to small cap stocks in emerging markets. Below, we profile the various options which investors now have to invest in this important sector [for more ETF ideas, sign up for our free ETF newsletter]:

Single Country Exposure

Many of the small cap emerging markets ETFs focus on specific economies, including Brazil, China, and India:

  • Market Vectors Brazil Small-Cap ETF (BRF): This ETF provides exposure to publicly traded small cap companies that generate ate least 50% of their revenues in Brazil. The 63 securities that make up this fund fall into various corners of the market, with financials (25%), consumer goods (18%), and industrial materials (15%) receiving the highest sector weightings [see BRF's holdings here]. While the large cap Brazilian ETF has struggled this year, BRF has surged; this fund is up more than 10% year-to-date.
  • Claymore/AlphaShares China Small Cap Index ETF (HAO): Claymore‘s HAO offers an alternative to the ultra-popular FXI, which is dominated by large cap stocks. HAO focuses on small cap Chinese stocks, tracking the AlphaShares China Small Cap Index. HAO is made up of 155 holdings which are spread out across several market segments, with a tilt towards industrial materials. So far in 2010, HAO is among the best performers in the China Equities ETFdb Category [see HAO's fundamentals here].
  • India Small Cap ETF (SCIN): This relatively new ETF offers exposure to small cap stocks in India, one of the world’s fastest growing economies. SCIN holds about 75 companies that have been chosen to represent small market cap companies in India, including a heavy tilt towards consumer products and services [see more on SCIN's fact sheet]. In its short life, the ETF has gained nearly 10%.
  • India Small-Cap Index ETF (SCIF): The recently-launched SCIF also offers exposure to small cap Indian stocks. SCIF maintains about 120 individual securities, and also charges an expense ratio of 0.85%.

Regional/Global Exposure

For investors looking to cast a wider net there are a number of small cap funds that offer more diversified exposure to emerging markets, including both regional and global ETFs:

  • SPDR S&P Emerging Markets Small Cap ETF (EWX): This ETF invests in more than 500 individual small cap emerging market stocks. EWX maintains exposure to a number of countries, including big weightings in Taiwan, China, India, Brazil, and Turkey. EWX has been on a hot streak lately, with gains of more than 12% this year and 25% in the past 52 weeks.
  • WisdomTree Emerging Market SmallCap Fund (DGS): This ETF invests in companies that fall in the bottom 10% of the WisdomTree Emerging Markets Dividend Index. DGS is similar in some ways to EWX, but the methodology of the underlying index results in a tilt towards the financial sector of the emerging markets world. DGS has also turned in an impressive 2010 performance, gaining more than 13% on the year [see also Five ETFs For Your IRA].
  • Latin America Small-Cap Index ETF (LATM): LATM offers exposure to small cap companies that are headquartered in or generate a majority of their revenue in Latin America. Brazil and Mexico combine to make up over half of this fund’s assets, with the remainder spread across a number of rapidly-expanding Latin American economies. LATM is one of the more recent additions to the ETF lineup, but has turned in impressive performance figures since launching in April [see LATM's performance charts here].

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Disclosure: Photos courtesy of Jialiang Gao and Anappaiah. No positions at time of writing.