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Why Invest in Emerging Markets Small Cap Stocks?

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Small Cap Stocks?

The notion of a “small-cap premium” (i.e. that smaller capitalization

stocks show persistent outperformance versus large

capitalization stocks) has become deeply established in

investors’ consciousness since its introduction by Fama and

French in 1993. Over the years, many investors have included

an explicit allocation to U.S. and international small-cap stocks

in their portfolios in order to benefit from the implied

outperformance of this segment of the market. In recent years,

there has been a growing interest in whether making a similar

allocation to emerging market small-cap stocks can be beneficial.

Tim Atwill, Ph.D., CFA Head of Investment Strategy

Mahesh Pritamani, Ph.D., CFA

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An investor in emerging market small-cap stocks typically has three main motivations behind their interest in the asset class:

• presumed higher return;

• better diversification with their developed equity allocation; and

• more “focused” exposure to the emerging markets, in that small-cap companies tend to be more domestically focused in their economic activities.

Below, we lay out the empirical evidence which supports these motivations. We show that while the return advantage and “pure exposure” arguments are strongly supported, the diversification benefit is relatively modest.

I. HIGHER RETURNS

Historically, small capitalization stocks have been seen as having higher potential returns than mid- and large-cap stocks. However, the bulk of the research examining this premium has fo-cused primarily on the U.S. markets, and, to a lesser extent, the international markets. Below, we compare the excess returns of the MSCI® Emerging Markets Small Cap Index to the MSCI Emerging Markets Index to evaluate whether a similar small-cap premium exists in emerging markets.

Figure 1: Excess Return of MSCI EM Small Cap Index vs MSCI EM Index, 2001-2014

2.83% 4.72% 4.60% -0.81%

-4.83% 0.20%

2.84%

-4.90% 35.29%

8.29%

-8.76%

3.99% 3.65% 3.20%

-15.00% -10.00% -5.00% 0.00% 5.00% 10.00% 15.00% 20.00% 25.00% 30.00% 35.00% 40.00%

EM SmCap Premium by Year

Source: Parametric, MSCI, as of 12/31/2014.

Figure 1 shows that in most years, small-cap stocks earn a relative premium to large- and mid-cap stocks. However, as with most matters in investing, there is no such thing as a free lunch, and several years had notable underperformance. Moreover, the oversized small-cap premium in 2009 highlights the timing risk associated with trying to capture the small-cap premium. This is also evi-dent in Figure 2 which shows the annualized small-cap premium on a rolling 3-year basis, where the realized premium ranges from -5.4% to 9.2%.

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Figure 2: Rolling 3-Year Annualized Excess Return of MSCI EM Small Cap Index vs MSCI EM Index

-8.00% -6.00% -4.00% -2.00% 0.00% 2.00% 4.00% 6.00% 8.00% 10.00%

Source: Parametric, MSCI, as of 12/31/2014.

These results indicate that although there is evidence of a small-cap premium in the emerging markets, one has to be invested for the long-term in order to earn it.

II. LOWER CORRELATION WITH DEVELOPED MARKET EQUITIES

Many argue that small-cap companies are more focused on their local economies, and because of this are less connected to the global economy. Accordingly, such small-cap stocks should provide higher diversification benefits within an investor’s portfolio, versus the benefit from buy-ing equities of larger, more globally-focused companies, which are included in more traditional emerging markets equity allocations.

To demonstrate the diversification benefits associated with investing in emerging market small-cap stocks, we calculate the correlation of the MSCI World Index (which represents the equities of the developed markets) to the MSCI Emerging Markets Index, as well as the MSCI Emerging Markets Small Cap Index.

Figure 3: Rolling 3-year Correlation with MSCI World Monthly Returns, 2003-2014

0.75 0.80 0.85 0.90 0.95 1.00

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As can be seen, emerging market small-cap stocks have historically shown a modestly lower correlation with the developed markets than large and mid-cap emerging market stocks. That is to say, emerging market small-cap stocks should provide a higher degree of diversification if in-cluded in an investor’s portfolio. Moreover, Figure 3 shows that this diversification benefit persists over most time periods. Therefore, a portfolio which includes an allocation to emerging market small cap stocks should expect to achieve some minor benefits from this lower correlation, includ-ing lower predicted portfolio volatility versus a similar portfolio which only includes large-and-mid-cap emerging market stocks.

III. A “FOCUSED” EMERGING MARKETS EXPOSURE

One of the reasons for investing in emerging markets, in general, is to gain exposure to smaller, less developed economies which have the potential to grow at a faster rate than developed economies. However, given the globalization of the world economy, several emerging market countries now have a small number of companies that are global in nature and known worldwide. A prime example of this is Korea-based Samsung, a truly global company, whose consumer prod-ucts (such as TVs and smart phones) are bought all over the world and whose profitability is more likely tied to the world economy than the local Korean economy.

A portion of the MSCI Emerging Markets Index constituents is in such global companies, under-cutting to some degree this motivation for investing in the emerging markets. By avoiding such companies, an investor in the small-cap segment of the emerging markets has the potential to obtain an exposure more focused on the local emerging market economies.

To quantify this, we look at each company within both the MSCI EM Small Cap Index and the MSCI EM Index, and calculate the percentage of revenue which comes from outside its “home” country. We then capitalization-weight these percentages for each index, and present the results below.

Figure 4: Percentage of Sales from Foreign Countries, Weighted by Market Capitalization, 2002 & 2013 Global Total Emerging Markets

Year Large/Mid Small Large/Mid Small

2002 41% 27% 30% 24%

2013 48% 31% 32% 24%

Source: MSCI, as of 12/31/2013.

As shown in Figure 4, emerging market small-cap companies do receive much less of their rev-enue from outside their home economies (approximately one-quarter, versus almost one-third for large/mid-cap stocks). In addition, this focus on local economies remained relatively static over the past decade, while globally, small-cap companies saw growth in foreign revenues. This data suggests that an investor in the small-cap segment of the emerging markets captures a “focused” exposure to the local emerging market economies, because small-cap names are generally more reflective of local economies, and that this focus is more persistent than is observed globally.

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About Parametric

Parametric, headquartered in Seattle, WA, is a leading global asset management firm, providing investment strategies and customized exposure management to institutions and individual investors around the world. Parametric offers a variety of rules-based, risk-controlled investment strategies, including alpha-seeking equity, alternative and options strate-gies, as well as implementation services, including customized equity, traditional overlay and centralized portfolio manage-ment. Parametric is a majority-owned subsidiary of Eaton Vance Corp. and offers these capabilities through investment centers in Seattle, WA, Minneapolis, MN and Westport, CT

change without notice, as are statements of financial market trends, which are based on current market conditions. We believe the information provided here is reliable, but do not warrant its accuracy or completeness. This material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. Past performance is not indicative of future returns. The views and strategies described may not be suitable for all investors. Parametric does not provide legal, tax and/or accounting advice or services. Clients should consult with their own tax or legal advisor prior to entering into any transaction or strategy described herein. Charts, graphs and other visual presentations and text

infor-Global market investing, (including developed, emerging and frontier markets) carries additional risks and/or costs includ-ing but not limited to: political, economic, financial market, currency exchange, liquidity, accounting, and trading capability risks. Future investments may be made under different eco-nomic conditions, in different securities and using different investment strategies. The currency used in all calculations is the U.S. dollar.

It is not possible to invest directly in an index. “MSCI” and MSCI Index names are service marks of MSCI Inc. (“MSCI”) or its affiliates. The strategy is not sponsored, guaranteed or endorsed by MSCI or its affiliates. MSCI makes no warranty

CONCLUSION

Investors currently hear many arguments for investing in emerging market small-cap stocks, and while these arguments appeal to intuition, we have found varying degrees of support for them in the historical data. After exploring the three most common reasons for investing in the emerg-ing market small-cap stocks – earnemerg-ing a small-cap premium, realizemerg-ing the benefits of increased diversification, and achieving a more focused exposure to the local economies in emerging market countries – we find supporting evidence for all three of these arguments. One can potentially earn a small-cap premium by investing in small-cap stocks, though there is the risk that small-cap stocks will underperform large- and mid-cap stocks over multiple years. Historical evidence also demonstrates that although emerging market small-cap stocks are less correlated with the de-veloped markets, this diversification benefit is relatively modest in size. It also appears that small companies in the emerging markets are more focused on their local markets, and so are potentially well positioned to benefit from the higher expected growth rates in these developing economies. All in all, we find the data encouraging for those investors who are considering a long-term strate-gic allocation to emerging markets small-cap stocks.

Figure

Figure 1: Excess Return of MSCI EM Small Cap Index vs MSCI EM Index, 2001-2014
Figure 2: Rolling 3-Year Annualized Excess Return of MSCI EM Small Cap Index vs MSCI EM Index -8.00%-6.00%-4.00%-2.00%0.00%2.00%4.00%6.00%8.00%10.00%
Figure 4: Percentage of Sales from Foreign Countries, Weighted by Market Capitalization, 2002 & 2013

References

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