BRIC ETF Investing: Small Cap Edition

by on April 28, 2011 | ETFs Mentioned:

In recent years interest in achieving exposure to emerging markets has intensified tremendously, as the developing economies of the world have established themselves as the clear leaders of GDP growth while advanced economies have struggled to regain their footing. While there are dozens of countries that fall under “emerging” status, exposure to this investment strategy has generally focused around the BRIC bloc that includes four economies expected to see their contribution to global GDP swell in coming decades.

The BRIC economies–Brazil, Russia, India, and China–have very little in common in terms of geography, culture, or even the makeup of their respective economies. The term was originally coined by a Goldman Sachs economist who had never visited three of the four countries but believed that the collective economies would grow to eventually surpass the six largest western economies in terms of economic size and importance. What seemed like a ludicrously bold prediction a decade ago has become an increasingly likely scenario, as the BRIC economies have grown tremendously over the last several years–and are now represented among the two largest economies in the world [see the Definitive Guide To BRIC ETFs].

ETFs have become a popular way to gain exposure to emerging markets, as the low cost structures and inherent diversification are appealing to those looking to enhance the international component of their portfolios. While the BRICs are represented heavily in most emerging markets ETFs, there are also a handful of funds dedicated specifically to these four economies. Currently, there are three pure play BRIC ETFs:

  • iShares MSCI BRIC Index Fund (BKF)
  • Guggenheim BRIC ETF (EEB)
  • SPDR S&P BRIC 40 ETF (BIK)

Like many international equity ETFs, these BRIC products are subject to certain biases. Specifically, they are dominated by mega cap and large cap names:

ETF Mega/Large Cap Holdings Small Cap Holdings
BKF 77.4% 0.3%
EEB 86.2% 0.7%
BIK 86.1% 0.0%
Source: Morningstar

This large cap focus is not necessarily undesirable; each of these funds has delivered impressive performances over the last several years. But the focus exclusively on large cap stocks can introduce some biases, including tilts towards the energy and financial sectors. And because large cap companies are more likely to generate revenues overseas or be impacted by macroeconomic factors, they may be less of a “pure play” on the local BRIC economies. Potentially, the connection between the positive demographic trends and growing local consumption will be diminished in a strategy that involves exclusively large cap companies [Emerging Market Investing: Seven Factors To Consider].

There isn’t yet a small cap BRIC ETF available, but investors are able to access small cap stocks in each of the BRIC economies independently through ETFs. These funds can be used to create more balanced emerging market exposure, tapping in to an asset class that may represent the best option for accessing the emerging market giants:

Brazil

The most popular way to play Brazil is through EWZ, a fund consisting primarily of large cap companies and concentrated heavily in oil giant PetroBras and mining firm Vale. Adding small caps to this type of exposure brings greater balance across sectors, increasing weights afforded to consumer companies. For investors seeking to access small cap Brazilian stocks, there are multiple options available:

  • Market Vectors Brazil Small Cap ETF (BRF)
  • iShares MSCI Brazil Small Cap Index Fund (EWZS)

The exposure offered by these two ETFs is generally similar, including balance across sectors of the Brazilian economy and depth of holdings. Moreover, both funds charge an expense ratio of 0.65%, making them similar from a cost efficiency perspective as well [see BRF holdings].

Russia

There are a handful of Russia ETFs available that focus primarily on large cap stocks, including RSX, RBL, and ERUS. Each of these funds is weighted heavily towards oil and gas companies, with the energy sector accounting for as much as half of total assets. While that composition may accurately reflect the Russian economy, it may be less than desirable from a balanced investment perspective. The recently launched Market Vectors Russia Small Cap ETF (RSXJ) offers a way to round out Russia exposure, as this fund has very little exposure to energy companies [see Under The Hood Of The New Russia ETF].

India

India is a particularly challenging investment destination, as the world’s most populous democracy maintains tremendous economic potential but also faces significant hurdles–including inflationary pressures and high levels of corruption. Again, there are a number of India ETFs that focus primarily on large cap stocks, including EPI, INP, PIN, and INDY. There are also multiple choices for those seeking to invest in small cap Indian stocks, an asset class that could surge if the Indian economy comes close to realizing its full potential:

  • EGShares Small Cap India ETF (SCIN)
  • Market Vectors Small Cap India ETF (SCIF)

These ETFs offer generally similar exposure, though the methodologies employed are slightly different. SCIF includes more total holdings and a larger allocation to industrials, while SCIN holds fewer total stocks and is more balanced from a sector allocation perspective [see SCIN holdings].

China

China is now among the most important economies in the world, representing a significant portion of global GDP growth. While a number of ETFs offer exposure to Chinese stocks (there are 19 in the China Equities ETFdb Category), these funds are subject to some significant biases. Many are focused exclusively on large caps, which results in tilts towards state owned energy companies and completely overlooking the tech and consumer sector. There are a couple of small cap China ETFs that can be used to round out exposure:

  • iShares MSCI China Small Cap Index Fund (ECNS)
  • Guggenheim China Small Cap ETF (HAO)

Again, the exposure offered by these two ETFs will be generally similar–though there are some differences. ECNS is a bit cheaper and casts a wider net, including more individual names in its portfolio [see breakdown of ECNS holdings]. Either could be a nice complement to FXI or other large cap heavy China ETFs.

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Disclosure: Long BRF.