A Valuable Piece Of The Emerging Markets Puzzle

When allocating to emerging markets, investors repeat a strategy they're comfortable with when it comes to domestic equities. That being often substantial allocations to large-cap stocks at the expense of small-caps.

The problem is especially acute with emerging markets exchange traded funds because the indexes many of these ETFs benchmark feature scant small-cap exposure. For example, the widely followed MSCI Emerging Markets Index allocates less than 2 percent of its weight to smaller stocks. Too much large-cap exposure in emerging markets comes with its own set of problems.

“A specific risk to EM is that many cap-weighted indexes and ETFs are heavily tilted toward large state-owned enterprises,” WisdomTree said in a recent note. “These companies can be managed inefficiently and do not always have the interests of shareholders at the top of their list of priorities (consider a hypothetical government-run company trying to simultaneously balance maximizing both profits and employment). Investing in companies with smaller market caps will largely avoid many of these large, unproductive enterprises.”

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The WisdomTree Emerging Markets SmallCap Dividend Fund DGS helps investors add a valuable piece to the emerging markets investing puzzle. In fact, DGS is soaring while domestic small-caps are struggling.

Year-to-date, DGS is up more than 15 percent while the Russell 2000 is clinging to a barely noticeable gain. Add to that, DGS has been almost 300 basis points less volatile than the U.S. small-cap benchmark this year. Oh, and DGS is also topping the MSCI Emerging Markets Index by 220 basis points this year while being less volatile.

Like U.S. small-caps, smaller emerging markets companies are more focused on their local economies, which can be advantageous as emerging markets consumers grow and these economies continue recovering.

“Smaller, more domestically oriented companies will typically conduct more of their business in their local markets,” WisdomTree said. “This is an organic way to access the much-desired rise of the EM middle class consumer theme—which McKinsey referred to as 'the biggest growth opportunity in the history of capitalism^'—without being constrained to just the two consumer sectors.”

DGS's underlying index yields almost 4.2 percent, more than triple the dividend yield on the Russell 2000. The ETF's index trades at an earnings discount to the MSCI Emerging Markets Index and major U.S. small-cap benchmarks.