Can BRIC Small-Cap ETFs do it Again in 2013?

Despite a slack performance by the iShares MSCI Brazil Index Fund EWZ, which is off almost 4.5 percent for the year, the four major country-specific ETFs tracking the BRIC nations have performed well as a group. The other three ETFs are the iShares FTSE China 25 Index Fund FXI, the WisdomTree India Earnings ETF EPI and the Market Vectors Russia ETF RSX. Throw in EWZ and the average return for that quartet of BRIC ETFs is 9.1 percent. That is solid, but not aw-inspiring, particularly when the far less volatile SPDR S&P 500 SPY is up 13.4 percent. The 2012 picture for BRIC ETFs is a bit prettier at the small-cap level. Using the Market Vectors Brazil Small-Cap ETF BRF, the Market Vectors India Small-Cap ETF SCIF, the Guggenheim China Small-Cap ETF HAO and the Market Vectors Russia ETF RSXJ would have generated an average return of nearly 11.4 percent across the four funds and that includes a loss of almost 11.8 percent for the Market Vectors Russia Small-Cap ETF. If investors swapped out of BRF in favor of the iShares MSCI Brazil Small Cap Index Fund EWZS and out of the SCIF in favor of the EGShares India Small-Cap ETF SCIN, the average return for a quartet of BRIC small-cap ETFs jumps to 14.3 percent. So split the difference between the two combinations – BRF, SCIF, HAO and RSJX and EWZS, HAO, RSXJ and SCIN and the average return between the two groups is about 13 percent. Either way, investors that wanted exposure to each BRIC nation on an individual basis would have done better with small-caps ETFs than with large-cap equivalents. With just a few trading days left in 2012, the question is whether BRIC small-caps will continue outperforming in 2013. The answer should be addressed at the country level to start. Russia Starting with Russia makes sense because while the Market Vectors Russia ETF has been a laggard itself with a gain of just under eight percent, its small-cap counterpart RSXJ, has been far worse with the aforementioned 11.8 percent loss. The bottom line is Russia has been a BRIC laggard this year relative to China and India and only looks good in comparison to Brazil. However, there are some positive signs for Russia bulls, starting with valuation. Investors have heard it all before, but the equity valuations across the BRIC nations can be described as compelling. While Russia historically trades at a discount to the broader emerging markets universe, Russian are now inexpensive relative to historical standards. As for Russian small-caps, they are even cheaper than the large-caps. At the end of November, RSXJ had a P/E ratio of 3.4 and a price-to-book ratio of just 0.8. Earlier this year, J.P. Morgan noted Russian equities were trading at 3.6 times price to free cash flow, well below the 10-year average of 4.9. There is also talk that Russia, in an effort to attract more foreign investment, is legitimately working to diversify its economy. That too would benefit RSXJ because by the standards of energy-heavy large-cap Russia ETFs, RSXJ is diverse. Energy names account for over a quarter of the ETF's weight, but materials and industrial names are also on prominent display. Additionally, the Russian government has passed a law mandating that state-owned firms start doling 25 percent of their profits in the form of dividends. Russian firms have a reputation for being highly profitable, broadly speaking, and the country's new found affinity for dividends from state-owned firms could lead to more dividend increases from an array of firms. RSXJ's exposure to energy, financial services and materials names positions the ETF to take advantage of that trend, implying the fund should perform better in 2013. India In addition to SCIF and SCIN, there is another India small-cap ETF on the market, the newly minted iShares MSCI India Small Cap Index Fund SMIN. Over the past six months, all three have performed admirably, though SCIN and SMIN have been the better bets. With the recent bout of weakness in Indian information technology firm Infosys, a marquee component in many India large-cap ETFs, the small-cap funds once again look like fine avenues for playing Asia's third-largest economy. The Indian consumer will be the story that drives the returns offered by many Indian small-caps – in either direction. There is evidence that story is starting to take hold in the way India bulls envisioned. Just look at the returns offered by the EGShares India Consumer ETF INCO and the good news the small-cap funds are levered to that story as well. Over 21 percent of SCIN's sector allocations are direct plays on the consumer. SCIF is in the area of 20 percent while a combined 23.7 percent of SMIN's weight goes to discretionary and staples names. The issue is by how much will the small-cap ETFs outpace their large-cap rivals by. For example, SCIN has outperformed EPI by about 860 basis points in 2012. That is a wide chasm and that pace may be difficult to maintain two years in a row. Brazil Charles Dickens once wrote about tales of two cities, but the varying performances of Brazil large-cap ETFs, such as EWZ, and small-cap funds, such as BRF and EWZS, paint a picture of two Brazils. Several issues explain the chasm between Brazilian large- and small-caps in 2012. First, global investors spent much of 2012 fretting about an economic slowdown in China, Brazil's top trading partner. Predictably, that hampered shares of Brazilian energy and materials names. Those sectors combine for over 36 percent of EWZ's weight, but only receive token allocations in BRF and EWZS. Second, Brazil's efforts to stimulate the domestic economy through infrastructure programs have largely passed over large-caps. However, various government stimulus efforts, whether it be consumption taxes or the aforementioned infrastructure largess, have boosted Brazil's small-caps. Third, despite interest rates on consumer credit that would be considered absurdly high in the developed word, the Brazilian consumer is alive and kicking. A 31 percent gain for the Global X Brazil Consumer ETF BRAQ says as much. That has been good news for BRF and EWZS as well as those funds allocate 28 percent and 43 percent of their weights, respectively, to consumer-related shares. Brazilian small-caps now face competing valuations views. In September, Brazil's small-cap index touched a book value of 1.59, according to Bloomberg. That is frothy by historical standards. EWZS has a P/E ratio of 24.35 and a price-to-book ratio of 2.39, according to iShares data. BRF trades at 18.13 times earnings and 1.44 times book value, Market Vectors data indicate. As measured by the iShares Russell 2000 Index Fund IWM, U.S. small-caps are more expensive. That ETF has a P/E ratio of 25.22 and a price-to-book ratio of 3.1. China When Chinese ETFs are performing well, the Guggenheim China Small-Cap ETF HAO usually outpaces the iShares FTSE China 25 Index Fund FXI. On the way down, the opposite is true, but investors must acknowledge China ETFs have perked up over the past three months. Over that time, HAO has outperformed FXI by almost 500 basis points. Year-to-date, HAO's advantage of FXI is nearly 600 basis points. Clearly, a big risk to HAO's potential upside in 2013 is the controversy that often surrounds Chinese small-caps. Fraudulent accounting, reverse mergers and myriad other unsavory acts have help Chinese small-caps become ensconced in controversy. Regarding HAO, there is some good news. Many of worst offenders among controversial Chinese small-caps are found in the media, Internet, technology and alternative energy sectors. Those industry groups receive scant representation in HAO. Another advantage HAO offers is that it is home to 226 stocks, none of which accounts for more than 1.13 percent of the fund's weight. That means if a Sino Forest-like debacle repeats itself with one of HAO's holdings, the ETF is not likely to suffer significant losses. HAO's next advantage is exposure to the Chinese consumer through a combined allocation of 24 percent to discretionary and staples names. With China's government working diligently to steer the world's second-largest economy towards more domestic consumption, HAO is positioned to benefit if those efforts prove successful. Then there is valuation. For what felt like an eternity, China bulls kept saying how cheap Chinese stocks were. The recent bounce indicates investors have finally bought into that thesis. As measured by HAO, Chinese small-caps are even cheaper. HAO has a P/E ratio of 7.9 and a price-to-book ratio of just one, according to Guggenheim data. Not only does that mean the ETF is far less expensive than U.S. small-caps as tracked by IWM, but HAO is also less pricey than FXI. FXI trades at almost 12.9 times earnings with a price-to-book ratio of 1.61. All this is a long way of saying, yes, HAO can repeat its 2012 bullishness in 2013. For more on ETFs, click here.