Why Invest in Emerging Markets Small Cap Stocks?

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1 March 2015 Tim Atwill, Ph.D., CFA Head of Investment Strategy Mahesh Pritamani, Ph.D., CFA Senior Researcher Why Invest in Emerging Markets 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 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. Parametric 1918 Eighth Avenue Suite 3100 Seattle, WA T F Parametric Portfolio Associates LLC.

2 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 focused 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, % 35.00% 30.00% 25.00% 20.00% 15.00% 10.00% 5.00% 0.00% -5.00% % % 2.83% 4.72% 4.60% -0.81% EM SmCap Premium by Year -4.83% 0.20% 2.84% -4.90% 35.29% 8.29% -8.76% 3.99% 3.65% 3.20% Figure 1 shows that in most years, small-cap stocks earn a relative premium to large- and midcap 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 evident 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% Parametric Portfolio Associates LLC. 02

3 Figure 2: Rolling 3-Year Annualized Excess Return of MSCI EM Small Cap Index vs MSCI EM Index 10.00% 8.00% 6.00% 4.00% 2.00% 0.00% -2.00% -4.00% -6.00% -8.00% 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 buying 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 smallcap 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, MSCI EM MSCI EM SmCap Parametric Portfolio Associates LLC. 03

4 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 included 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, including lower predicted portfolio volatility versus a similar portfolio which only includes large-and-midcap 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 products (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, undercutting 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 % 27% 30% 24% % 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 revenue 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 Parametric Portfolio Associates LLC. 04

5 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 emerging market small-cap stocks earning a small-cap premium, realizing 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 developed 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 strategic allocation to emerging markets small-cap stocks. 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 strategies, as well as implementation services, including customized equity, traditional overlay and centralized portfolio management. 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 (home to Parametric subsidiary Parametric Risk Advisors LLC, an SEC-registered investment adviser). Important Information and Disclosure Parametric Portfolio Associates LLC ( Parametric ), headquartered in Seattle, Washington, is registered as an investment adviser under the United States Securities and Exchange Commission Investment Advisers Act of This information is intended solely to report on investment strategies and opportunities identified by Parametric. Opinions and estimates offered constitute our judgment and are subject to 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. 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