Why This Small-Cap ETF Is Soaring

In this space earlier this week, we examined the WisdomTree Emerging Markets SmallCap Dividend Fund DGS and that exchange traded fund's stellar year-to-date performance. With only modestly higher volatility, DGS is trouncing U.S. small-cap benchmarks such as the Russell 2000 Index and the S&P SmallCap 600 Index.

DGS also trumps its U.S. equivalents on yield. The ETF's underlying index yields 4 percent, more than triple the 1.46 percent found on the Russell 2000. Combine that yield with the better risk-adjusted returns, and it's clear DGS has been a vastly superior bet to U.S. equivalents this year.

Inquisitive investors are apt to want to know more about DGS and what is driving the ETF's performance this year. Those are valid queries. Fortunately, pinpointing DGS's outperformance of its U.S. counterparts and large-cap emerging markets benchmarks isn't difficult.

Related Link: A First-Place Medal For This Silver ETF, Up 280% In 2016

Brazil, Latin America's largest economy and one of the world's best-performing equity markets this year, has been a key contributor of the upside delivered by DGS this year. 

“Brazil has been a great performer, partly with its currency but also the stock selection within the small-cap side of the market. Brazil small caps in DGS are up over 80% in 2016 and averaged over 9% weight in the DGS. The MSCI EM Small Cap Index had less than 3% weight to Brazil small caps, and this led to 450 basis point (bps) of outperformance over the MSCI Emerging Markets Small Cap Index,” said WisdomTree Research Director Jeremy Schwartz in a note out Thursday. 

Brazilian small caps are on a torrid pace this year as an ETF dedicated to smaller Brazilian stocks is outperforming the benchmark large-cap Brazil ETF by about 600 basis points. DGS currently devotes 12 percent of its weight to Brazil, making it the ETF's third-largest country weight behind Taiwan and China. 

Another country found in DGS that has some small caps investors have a tendency to overlook is Indonesia, Southeast Asia's largest economy. DGS allocates 3.65 percent of its weight to Indonesian stocks, an overweight of 90 basis points relative to the MSCI Emerging Markets Index. Indonesia is the ninth-largest country weight in DGS while it is merely the eleventh-largest in the MSCI Emerging Markets Index.

And just because DGS holds emerging markets small caps, that does not mean investors are exposed to excessive volatility.

“Also, for those investors who think that small-cap companies are more volatile than large caps and that it sounds especially volatile to allocate to emerging market small caps, it may be surprising that since the inception of DGS, the beta of this Index relative to the MSCI Emerging Markets Index of large caps was .89 and the volatility was 1.13% lower,” adds Schwartz.