Smaller Stocks Defy Emerging-Market Weakness

Emerging-market (EM) stocks have hit a rough patch, but shares of smaller companies have held up well. The recent resilience shows how smaller stocks offer investors an attractive way to access emerging markets without taking on more large-cap or China risk.

It’s been a rough summer for EM stocks. Mounting concerns about regulation in China triggered a sharp downturn in Chinese stocks, erasing gains in the MSCI Emerging Markets Index of large-cap stocks this year through July 31. Yet smaller EM stocks have held up well. The MSCI Emerging Markets Small Cap Index has advanced by 18.2% over the same period, defying the weakness of larger-cap EM stocks (Display, left).

Why the stark difference? We think there are several reasons related to the different structure of the two markets as well as the broader features that make smaller stocks attractive.

Three Differences in the Smaller-Cap Market

First, the smaller-cap EM benchmark’s regional composition is quite different than its large-cap peer (Display, right). In particular, the MSCI EM Small Cap only holds 8.7% in Chinese stocks, about a quarter of the China weight in the MSCI EM. That means smaller-cap allocations will be less vulnerable to sharp swings in the volatile Chinese market.

Second, sector allocation is different too. The smaller-cap index has less exposure to industries driven by macroeconomic factors such as financials, consumer discretionary and energy. The lower weight in energy also provides ample opportunity for environmentally focused active investors to construct an EM small-cap portfolio with a much lower carbon footprint than the broader EM universe.

Third, small-cap stocks tend to have less analyst coverage than larger companies. This is true for smaller stocks globally, as well as in emerging countries. Lower analyst coverage provides investors with greater opportunity to develop differentiated insights on individual companies that help generate outperformance.